An Ongoing Eye on InflationMichael Englund
Though there are still many encouraging signs for the likely trajectory of U.S. core inflation, the Federal Reserve won't be able to ignore the sharp up-trend in many of the available inflation measures when they review risks at the May 10 meeting of the Federal Open Market Committee (FOMC).
The market expects another 25 basis-point tightening, bringing the federal funds rate to 5%, but is looking for some evidence in the wording of the statement that a pause will come in time to prevent an additional hike in June, to 5.25%. A change in the statement that heightens the apparent importance of interim data would be an encouraging signal, but a downgrading of the inflation-risk reference is unlikely.
The best inflation news for the Fed during the intra-meeting period came from the first-quarter employment cost index (ECI) report, which revealed a remarkable slowing in benefits costs to only 0.5% in the first quarter that allowed a modest 0.6% gain in the index overall. Benefits-cost growth has been plummeting from its recent 7.1% peak in the second quarter of 2004 to "only" a 3.4% rate in the first quarter. Though this is still faster than the 2.7% year-over-year wage and salary growth rate by this measure, it has allowed year-over-year growth for the ECI overall to slow to 2.8%, which is the lowest overall rate since the second quarter of 1997.
However, the wage statistics from the monthly employment report tell a different story. Here, the figures released last Friday revealed a sharp surge in the seasonally unadjusted year-over-year growth rate for wages to 4.2%, which is the highest rate since March, 2001, and is close to the prior cyclical high of 4.4% in May, 1998. These figures, alongside the ECI's benefits-cost data, would suggest a more mixed "cost push" inflation outlook, and these figures alone may be seen as downright problematic. As we frequently note, the monthly wage figures have shown a clear upward trend since the unemployment rate passed downward through 5.5% in each of the last two examples.
For the upside risk, clearly the biggest shock to U.S. inflation over the last two years has come from oil prices, though the risk now appears linked more generally to commodity prices overall. Though nominal oil prices are obviously dancing around record highs, the run-up in inflation-adjusted terms still falls short of the $93 "real" peak in 1980 that we calculate using Consumer Price Index (CPI) data. In addition, oil prices are now roughly half as important for the economy and U.S. inflation as they were in 1980. Nevertheless, the upside shock to domestic inflation from soaring oil prices has been substantial.
The rise in oil prices, and now commodity prices more generally, has been associated with a downward trend in the dollar since February, 2002, that has gained steam in recent months. We see the modest upside correction in the dollar's value in 2005 as reflecting the notable mismatch in economic growth between the U.S. and other industrialized countries that is now unwinding, alongside the effects of 2005 repatriation.
EYE ON THE INDICES.
Dollar weakness should keep the up-trend in the U.S. trade price indexes intact -- especially for the overall import price index that is facing the double whammy of a falling dollar and soaring global energy prices in real terms.
The combination of rising oil and trade prices, alongside emerging strength in wage and salary gains, should continue to aggravate the overall CPI figures, and should eventually place upward pressure on core inflation as well. Headline year-over-year CPI inflation has outpaced core inflation consistently since mid-1999, with the exception of the one-year period following the September 11 terror attacks -- when we saw a global oil-price correction that proved temporary.
The inflation rates reported in the Fed's favorite "PCE chain price index" measure have consistently fallen just short of the comparable CPI rates, though it's clear that these figures also are likely to be seen as being at least somewhat problematic for Fed policy. Economists often cite a 1.5%-2% rate as desirable for this measure, and headline inflation here has consistently hovered closer to 3% since mid-2004. The core measure as of March is right at the 2% mark. Any up-trend in core inflation will presumably be seen by the Fed as a sign of cyclical inflation pressure that may not be welcome.
RESERVING ITS OPTIONS.
The broadest measure of inflation from the GDP accounts is the GDP chain price index, which is poised for a 3.3% gain in the second quarter that will be the fourth consecutive quarterly increase in the lofty 3.3%-3.5% range. We continue to assume a moderation in this measure through the second half of 2006, on the assumption that oil prices stabilize. Yet, the assumption of a "ceiling" in oil prices going forward is not one that policymakers can bank on.
The market assessment of inflation risks has shifted in May toward the high end of its 2.2%-2.9% band of the last two years according to Treasury Inflation-Protected Securities (TIPS) pricing, as current prices for 5-, 7-, and 10-year TIPS maturities are implying a rate of roughly 2.7%.
In total, though we think that the FOMC in Wednesday's meeting will attempt to leave the door open for the Committee to either tighten or pause at the June 28-29 meeting, they will have to maintain a cautious attitude regarding prospects for inflation. The reference to inflation in the last FOMC statement that "possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures" will be difficult for the Fed to credibly edit in a manner that would be taken favorably by bond bulls, given the mix of inflation data since the last meeting.