Inflation realities

As the Federal Reserve's inflation-obsessed (appropriately so) monetary-policy committee prepared to meet this week, the Energy Department reported that the average gasoline price across the nation reached $3.10 per gallon -- 2 cents below the nominal record set in September 2005, a week after Hurricane Katrina shut down oil-production, refinery and pipeline operations around the Gulf Coast. Three months later, the Katrina-related gas price had fallen nearly $1 per gallon. Unfortunately, few people expect such a plunge to occur over the next three months from a gasoline-price level that is now nearly 40 percent higher than it was three months ago.

After rising 3.3 percent in 2004 and 3.4 percent in 2005, the consumer price index (CPI) increased 2.5 percent last year. During the first quarter of 2007, however, the CPI advanced at a seasonally adjusted annual rate of 4.7 percent. Meanwhile, the price index for gross domestic product (GDP) increased last quarter at an annual rate of 4 percent, the fastest pace during any quarter since 1991 and more than twice as fast as the average annualized increase (1.8 percent) during the two previous quarters.

This is not to say that all the inflation news has been worrisome. The Fed's preferred inflation gauge is the Commerce Department's core personal consumption expenditures (PCE) price index, which excludes the volatile energy and food sectors. When Fed Chairman Ben Bernanke talks about his "comfort zone" of 1 to 2 percent, he is referring to the 12-month change in the core PCE price index. During the 12 months ending in March, the core PCE index increased 2.1 percent, which was down significantly from the 2.4 percent rate for the 12 months ending in February. By this standard, Mr. Bernanke is close to being comfortable. The Labor Department's CPI also has a core component, whose Fed target reportedly is about 2.5 percent over 12 months. This "comfort" target was reached in March, as the core CPI declined from January and February's level of 2.7 percent.

The Fed prefers food- and energy-excluding core price indexes because they are believed to better measure underlying inflationary trends and pressures. At the end of the month, however, consumers' credit-card and utility bills make no such distinction. The prices for gasoline and electricity are what they are. Without their inclusion, the concept of inflation would have little real meaning. When the prices for food and energy are in rapid decline, they effectively raise purchasing power. When they increase rapidly, they adversely affect purchasing power. One reason why real (i.e., inflation-adjusted) GDP increased last quarter at its slowest rate (1.3 percent) in three years is because the GDP price index, which measures economy-wide inflation, increased so much (4 percent). And now the Fed has two issues of concern: a slowdown in growth and an acceleration of economy-wide inflation.