- The Washington Times - Wednesday, May 2, 2007

For some time now the five major measures of core or underlying consumer inflation have been telling a discomforting tale.

The Federal Reserve’s preferred measure, the Commerce Department’s core personal consumption expenditure (PCE) index, which excludes all food and energy prices, has been rising by more than 2 percent year-over-year since spring 2004 — above the Fed’s 1 percent to 2 percent comfort zone. For the first quarter of this year the PCE core price index clocked in at 2.2 percent above last year’s first quarter.

The Labor Department’s core Consumer Price Index (CPI), which also excludes all food and energy, has been registering inflation above 2 percent most of the time since the autumn of 2004, with the year-over-year rate trending upward to 2.6 percent in the first quarter of 2007.

The Fed itself reports three other core inflation measures. The Federal Reserve Bank of Dallas, using Commerce Department data, estimates a trimmed mean PCE measure that doesn’t crudely exclude all food and energy prices, but examines each item in the total index and trims away volatile monthly price changes regardless of category. This more refined inflation rate breached 2 percent in April 2004 and has remained above that ever since.

The Federal Reserve Bank of Cleveland estimates two improved core inflation measures based on CPI data: a median rate and a trimmed mean rate. Both rates have been above 2 percent year-over-year and generally trending upward since spring 2005, with the median registering a disquieting 31/2 percent and the trimmed mean 2.8 percent this March.

Oddly, you won’t find any mention of the Fed-estimated core inflation rates in the minutes of the Federal Reserve’s policymaking Open Market Committee (FOMC) meetings or in the chairman’s speeches and testimony. But maybe it’s not so odd. Consider the havoc that would ensue if the Fed chairman talked about 3-1/2 percent core inflation.

As far back as May 2004, the FOMC has been expecting inflation to moderate. According to the minutes of its meeting that month, “most members saw low inflation as the most likely outcome.” Three years later committee members still expect it, though every major core inflation measure remains persistently above the Fed’s comfort ceiling. The minutes of the March 20-21, 2007, FOMC meeting read: “Most participants continued to expect that core inflation would slow gradually.”

The public, however, apparently thinks differently about the path of future inflation, judging from the University of Michigan’s survey of inflation expectations. Throughout the present economic recovery, consumers’ expectations of inflation one year ahead have been on a rising trend, measuring 3.3 percent this April. Expectations of inflation five to 10 years ahead have been trending upward since early 2003 and this April measured 3.4 percent. As Fed officials often remind us, price expectations can be self-fulfilling.

Earlier this year, economists Michael Bryan and Linsey Molloy wrote in the Cleveland Fed’s Economic Trends, “Expectation of higher inflation induces changes in economic behavior that impose costs on the economy, which, over time, are detrimental to long-term prosperity. … Rising inflation expectations may also help to perpetuate an otherwise temporary rise in prices, making the job of maintaining price stability more difficult to achieve.”

The FOMC finished raising the federal funds interest rate in June 2006, and by now the lagged inflation-restraining effect of the last increase probably is or will soon be wearing down. True, economic growth in the first quarter of this year was weak, though the reported number probably will be revised upward.

But this is likely a bump in the road, and the Fed is still expecting a stronger if moderate second half as the slump in housing mitigates. The current temporary slack in the economy will probably not be enough to restrain prices very much, and resources should remain sufficiently tight to allow businesses to pass on higher energy costs to consumers.

Profits remain healthy, and even though there is some room for producers to absorb rising costs, it may be wishful thinking to believe they will. Productivity growth has also slowed, as is to be expected at this stage of the business cycle, and this is likely to put further upward pressure on employment costs and prices.

At this stage of the cycle, economic forecasting is more than usually prone to error, leaving the Fed in a dilemma about what to do with interest rates. Nevertheless, the upside risks to inflation appear to exceed the downside risks to economic growth and inflation remains the Fed’s chief worry.

Though the FOMC minutes have stated that committee members expect core inflation to moderate over time, a dissonant note was sounded recently by Fed Gov. Frederic Mishkin, speaking at Bard College April 20: “Further reductions in inflation may take time. In the near-term, the recent rebound in prices for gasoline and other petroleum-based goods is likely to put upward pressure on the costs of many nonenergy goods and services.”

Futures traders are betting that the Fed will lower interest rates before year-end. That may be a bad bet.

Alfred Tella is former Georgetown University research professor of economics.

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