Inflation: Back from Vacation
The recent run of tepid inflation reports is about to come to an end. The last major inflation indicator for August, the personal consumption expenditure (PCE) chain price index, to be released Sept. 28, will mark the end of the year-over-year "honeymoon" for various U.S. headline inflation measures since the jumbo commodity price free fall starting in August of last year.
The upshot: Every major U.S. headline inflation measure will soar over the next three months because of comparisons unskewed by the effect of Hurricane Katrina as well as due to recent big commodity price gains.
Dates to Circle: Oct. 12, Oct. 17
For the domestic inflation measures, the first U.S. headline inflation pop will emerge in the producer price index (PPI) report Oct. 12, when the year-over-year rate will rise from a 2.2% low point in August to a 4.1% rate in September and 6.0% rate by October. The "Katrina peak" for this measure was 6.9%, when the hurricane-induced collapse of the oil industry infrastructure around the New Orleans and Houston areas—aggravated also by Hurricane Rita—prompted hefty gains in most energy and energy-sensitive prices. It may be a surprise to some when the year-over-year inflation pace for producer prices soars toward the Katrina peak without the help of a hurricane or other calamity.
The consumer price index (CPI) will show the same pattern, with the Oct. 17 report displaying a likely year-over-year rise from 2.0% in August to 2.8% in September. Further gains are likely to reach the 3.6% area in October, and the 3.9% area in November. The impending peak for this measure will fall short of the Katrina-based 4.7% unless we see a considerable further jump in energy prices.
Following the projected August drop in the year-over-year PCE chain price index mentioned above—to a 1.9% pace that would be associated with a likely downtick in the core rate (excluding food and energy prices) to 1.8%—this measure will also post a three-month upward climb, to a 3.2% rate, by November, vs. the Katrina apex of 3.9%. Again, the new peak assumes no particular supply disruptions like Katrina, just the accumulated weight of hefty U.S. price gains over the past eight to 10 months. Those gains have not appeared to be all that dramatic in the monthly reports because they were being compared against year-earlier figures that had been impacted by the Katrina effect.
Impact of Dollar's Plunge
To make matters worse, the outlook for commodity price gains is made particularly troublesome by the accelerated downtrend in the U.S. dollar over the past month that has been associated with the reversal in Federal Reserve policy.
The dollar drop of recent months will provide a solid boost to commodity prices through yearend, as will robust growth in world gross domestic product. Our global growth forecasts show that GDP growth in the developing world will more than fill the void of any U.S. slowdown over the near term, ensuring that 2007 will be the fourth straight year of extraordinary growth in global GDP.
The U.S. import and export price indexes are typically a source of inflation restraint in the U.S. economy, with a generally sideways path for these measures between the late-1980s and 2003. But with a dollar free fall alongside the hefty surge in world GDP growth over the past four years, the trade price indexes have been trending sharply upward.
The market may seek to treat the U.S. headline inflation surge through the fourth quarter as "aberrant" even though arguably it was the temporary lull over the last 12 months that marks the actual distortion.
Justifying the Rate Cut
In total, all the U.S. year-over-year headline inflation figures, and many nominal sales measures, will surge over the coming three months from troughs that we are now enjoying in the various August reports. This is occurring alongside robust growth in bank balance sheets and an associated boom in growth for loans, reserves, and the money supply. The Fed is focusing market attention on the potential for an economic slowdown and is easing monetary policy on the notion that downside economic risks exceed upside inflation risks. Is that what the central bank's balance of risk will look like by yearend if we do not see the sharp pullback in business and consumer spending that the Fed is now focused on averting?
Indeed, consider this: Fed Governor Donald Kohn's recent implication that the central bank is easing in response to falling asset values may haunt the Fed if economic weakness fails to materialize soon and especially if we see any unwelcome upticks in core inflation rates. How will Ben Bernanke & Co. justify its new lower trajectory for the Fed funds rate target if rate cuts are really aimed at stabilizing home prices—which could take years—rather than reacting to downside economic risks attributable to the credit crunch? If key U.S. economic measures fail to slow over the near-term beyond some short-term disruption effects, policymakers may have difficulty justifying even the current Fed funds rate target rate, let alone a potentially lower one by yearend.