The Fed: Trapped by Rhetoric?

The CPI is up, and though slowing growth is apt to cool prices, the Fed's chairman may feel he must abide by his tough talk on inflation

Has a more hawkish Federal Reserve painted itself into a corner on interest rates? Fed officials have issued a steady stream of tough words on inflation in recent weeks and with the release of a stronger than expected consumer price index (CPI) for May on June 14, policymakers may face some difficult decisions (see, 6/7/06, "No More Hints and Whispers"). The report suggests that the Federal Reserve will have no choice but to tighten at the June Federal Open Market Committee meeting, with a mounting likelihood that they will tighten at the August meeting as well.

The overall CPI jumped 0.4% in May—in line with economists' median forecast. But the surprise was a bigger than expected 0.3% increase in the core index, which excludes food and energy prices. That was above the median expectation of a 0.2% increase.


  As expected, energy prices were a major culprit in the overall price advance, climbing 2.4%. Gas prices increased 4.9%, though new vehicle prices dipped 0.3%. Half of the rise in core CPI was due to the 0.4% rise in shelter costs.

The core aggregate has been surprisingly firm so far in 2006, with an average gain of 0.26%. The strength in the core index is consistent with the upside in the core measures of both the trade price report and the producer price index (PPI).

On a year-ago basis, the overall index accelerated to a 4.2% pace from 3.5% in April, while the core sped up to 2.4% from 2.3%. The core index, which is more closely watched by the Fed, remains at the higher end of policymakers' comfort zone, and matches the prior 2.4% cyclical high.


  The figures revealed the same "hot" core figure seen in the May PPI report released June 13, but with an upside pop in the headline as well that sends a clear inflation warning signal to the markets. The report also reflects the same upside risks highlighted in the solid trade price numbers released in early June, and will dovetail with the Fed's new hawkishness to fuel fears of at least one more tightening, if not two or three.

How will the Fed talk its way out of this tricky situation in the statement following the June 28-29 FOMC meeting? Chairman Ben Bernanke will face quite a test, given the rhetorical trajectory he has set for himself. Though we at Action Economics think that the May CPI represents a digestible pop in core inflation in the middle of this business cycle—one that Bernanke's predecessor, Alan Greenspan, would likely have tried to ride out—the current Fed chief has set himself up to take on this jump with a policy response.

The dilemma for Bernanke: Since Fed policy moves typically take 6 to 18 months before they have a meaningful effect on inflation, he will have to shift to rhetoric that is more accepting of high inflation figures over the near term, with a focus on a projected moderation. Otherwise he will be pushed into an implausibly aggressive tightening trajectory.


  As it stands, the trend in core inflation will continue through at least August if not September, and hence at least two more FOMC meetings rather than just one. If the higher trajectory for shelter costs is seen as sustainable—as rents may be playing "catch up" to home prices—then the Fed's bind may be even greater.

Note that core CPI inflation in June will remain at 2.4% year-over-year, even if the core figure is flat. Our assumed 0.2% gain would leave this measure at 2.6%—or above the Fed's perceived 1.5%-2.5% comfort zone. This heightened year-over-year path would remain in place in ensuing months with each 0.2% CPI core gain, hence providing the Fed with no reprieve. Core CPI inflation, which rose to 2.4% on a year-over-year basis in May, will likely be in the 2.4%-2.6% range in the third quarter even if each core monthly gain is only 0.2%.

Under Greenspan, the focus of Fed commentary would likely have been placed more on a slowing economy, and a belief that the "pass-through" of post-Katrina price firmness to core inflation is at least partly a temporary effect of production bottlenecks for petroleum and petroleum-related chemical and construction supplies. Such Fedspeak would have provided at least some rhetorical cover for the Fed to "ride out" the rise in core inflation rates.


  With Bernanke's notably more hawkish rhetorical trajectory, however, it will be difficult for FOMC members to steer the focus back to the economy, or to the notion that the Fed will bank on "forecasts" of lower inflation when actual rates are rising.

We do think that they will make the transformation, but will probably need an additional tightening in August to a 5.5% target that we had previously expected by the first quarter of next year, before making such a shift. The economy will have meaningfully slowed by then, and forecasts of moderating inflation will be more acceptable.

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