American inflation Feeling the heat Jun 22nd 2006 | WASHINGTON, DC From
The Economist print edition Americas Federal Reserve gets a touch of the
vapours CENTRAL bankers are supposed to be calm, even a little boring. But the
governors of Americas Federal Reserve seem to have been seized by a sudden
panic about inflation. Virtually every Fed official has been worrying aloud
about rising prices. Ben Bernanke, the Feds chairman, warned about unwelcome
inflation on June 5th. Since then his colleagues have declared it to be
troubling, beyond their comfort level and even corrosive. This hawkish
talk has not been lost on financial markets, which now take for granted that
the federal funds rate will be pushed up by a quarter of a percentage point, to
5.25%, at the end of the central bankers next meeting on June 28th and 29th.
Judging by the price of futures contracts, markets see a better than even
chance of another quarter-point rise in August. Several
forecasters believe that short-term rates will reach 6% by early 2007. Less
than two months ago, Wall Street was worried that Mr Bernankes Fed would be
too soft on inflation. Now the opposite fear has taken hold. A rising chorus
wails that Fed officials have become obsessed with monthly inflation figures
and that their fixation will cause them to push interest rates too high and tip
the economy into recession. David Rosenberg, chief economist at Merrill Lynch,
puts the odds of a recession in 2007 above 40%. The idea that the Fed worries
too much about inflation comes from several quarters. Statistical boffins point
out that recent jumps in consumer prices are due to an acceleration in the
imputed cost of home ownership, an artificial figure that is calculated from
rental prices. Since nobody pays this price, the argument goes, the inflation
it causes should be discounted. Other economists reckon that with productivity
high and wages muted, a pernicious wage-price
spiral of the kind that lay behind soaring inflation in the 1970s is unlikely.
Higher energy prices may temporarily push up inflation, but with labour costs
so low, this one-off rise cannot last. These critics make some good points.
The central bankers have clearly been spooked by the recent jump in the core
consumer price index (CPI). The core measure excludes the volatile prices of
energy and food. Over the past three months this index has risen at an annual
rate of 3.8%, the fastest in more than a decade. But much of that jump is
thanks to a sharp rise in the cost of housing (which makes up almost 40% of
core CPI), particularly the category of owners equivalent rent which
estimates the cost of living in a house by looking at rents charged on similar
properties. Although this measure makes sense in theory (by living in your
house you forgo rental income), it may now be overstating inflationary
pressure. As the housing market has slowed, fewer people are buying
property, choosing to rent instead. That has pushed up rents. In turn, owners
equivalent rent has risen too, even though homeowners have seen no change in
the actual costs of owning their house. Because owners equivalent rent is
estimated net of utility prices, recent falls in gas and electricity bills have
paradoxically made matters worse. Statistical quirks, in short, are distorting
the picture. But what should central bankers do about it? Some suggest that
owners equivalent rent should simply be dropped from the inflation index. That
is what European statisticians have done. But credible central bankers cannot
suddenly ignore an inflation component when it starts behaving in ways they do
not like. That was the mistake made in the 1970s, when officials deluded
themselves that inflation was under control by excluding ever more prices from
their indices. The bigger point is that even if you take out housing costs
the recent acceleration in core consumer prices does
not disappear (see chart). And a variety of other gauges suggest that
underlying inflation is on the high side and rising. The deflator for core
personal-consumption expenditure (PCE), Fed officials favoured index, was up
2.1% in the year to April. The trimmed-mean PCE deflator, calculated by the
Dallas Fed, which excludes those prices that have risen and fallen the most
before taking a weighted average of the rest, is up 2.4%. The median
consumer-price index, calculated by the Cleveland Fed, is up 3%. Look at these
figures and the surprise is less that the central bankers are now so jumpy
about inflation than that they sounded so sanguine earlier this year. One
reason is that Fed officials, as much as their sceptics, were comforted by the
lack of wage pressure. Thanks to strong productivity growth and fairly modest
pay rises, the cost of workers relative to their output has slowed, rising only
0.3% over the past year, even as the jobless rate has fallen to 4.6%. It
is hard to see how prices could spiral out of control while labour costs
remain so subdued. So why are the central bankers suddenly worried now? One
explanation is that other determinants of short-term inflation, particularly
inflation expectations, have been flashing. Survey-based estimates of
consumers inflation expectations have all risen since last year. The hawkish
talk was doubtless designed to put a lid on them and put paid to the idea that
the Bernanke Fed was a soft touch. A rational phobia Some central bankers
are also wary of the most popular explanation for tepid wage growth, namely
that the integration of China and India into the world economy has put pressure
on workers elsewhere. In recent speeches, both Don Kohn, the Feds
vice-chairman, and Janet Yellen, president of the San Francisco Fed, argued
that globalisation had had only a modest effect on American inflation. Much of
Chinas price-dampening impact might prove temporary (see article). Both
pointed out that if globalisation had made Americas inflation rate less
sensitive to conditions at home, then it also made policy mistakes more costly.
Once inflation gets out of control it will be harder to wring out of the
system. These are all fair points and, on balance, the central bankers
concern about inflation seems prudent more than phobic. After all, monetary
policy is still not restrictive. Interest rates are only just positive in real
terms. And although growth is slowing, there is little sign that the economy
has stalled. The problem is that the Feds stern talk may backfire. The
statistical nuances of owners equivalent rent suggest that core inflation may
rise further and will remain above Mr Bernankes boundaries for the rest of the
year, even as the economy slows. If they are to avoid pushing up interest rates
too far, Fed officials may soon have to explain why figures they now regard as
troubling and corrosive are not so worrying after all. That
task would be easier if their rhetoric had been more boring in the first
place.
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