Is the Fed Dragging Its Feet?

It warned of inflation pressure in its recent statement, but CPI data indicate the problem may be worse than expected

By Michael Englund and Rick MacDonald

Just one day after the Federal Reserve warned markets that "pressures on inflation have picked up in recent months," a report on retail inflation in February drove the point home (see BW Online, 3/23/05, "The Fed's Stealthy Bias Shift"). The overall consumer price index for the month rose 0.4% -- higher than economists' median forecast of a 0.3% increase -- while the core index, which strips out volatile food and energy prices, increased 0.3% (median +0.2%).

The core gain in February allowed the year-over-year rate to rise to 2.4%, from 2.3% in January, to mark the highest rate since August, 2002. The rate has risen steadily from the cyclical low of 1.1% seen in December, 2003, and appears poised to reach the 2.7% area by the end of this year. As for the overall index, the monthly gain left it rising at 3%, year-over-year, the same as in January (see BW Online, 3/24/05, "The Fed May Be Talking Too Freely").

Hardly surprising, energy led the increase in the overall index in February with a gain of 2%, with gasoline jumping 3.2%. Strength in the core index was broad-based. The risk is for more strength over the near term in the inflation aggregates, given the elevated levels of various commodity prices through mid-March.


  The CPI data have matched earlier producer price index figures in providing a mild upside surprise that has extended the steady uptrend in "core" inflation, while revealing a mildly troubling overall inflation reading as well.

The accumulation of "pipeline" inflation pressures as gauged by most other measures indicates ongoing upside risk to consumer inflation over the coming months. Upside pops in the CPI are proving troublesome for the Fed's efforts to maintain a "measured" pace of policy tightening. This is unlikely to change over the coming months, given ongoing strength in commodity prices.

Year-over-year data continue to suggest that the low-inflation party is over. The last two times we saw a similar run-up in wholesale inflation (1994-95 and 1998), there was little response in retail inflation. But this time around, CPI core inflation is moving higher as well. Moreover, wholesale inflation never pushed through the rate of retail inflation in both 1994 and 1998. Yet this time, wholesale inflation has already pushed well above retail inflation.


  Overall, the U.S. enjoyed an unusual period of remarkably low "core" inflation in 2003. In 2004, the Fed indicated that it did not believe the sharp jump in commodity prices (and in wholesale inflation) would put upward pressure on retail inflation. But trends in actual inflation measures, commodity prices, pipeline pressure, and inflation expectations in 2005 all suggest the Fed should be growing less sanguine on the outlook (see BW Online, 3/24/05, "A Layman's Guide to Fedspeak").

Little wonder the Fed's language in its Mar. 22 statement about the economic outlook warned that inflation pressures may be worsening. Still, the upside strength in February's report will heighten Wall Street's concerns about whether the Fed is falling behind in its efforts to keep inflation at bay.

Englund is chief economist, and MacDonald global director of investment research, for Action Economics

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