Sunday, October 16, 2005

How Hot Is Inflation?

Friday the U.S. Bureau of Labor Statistics (BLS) announced that the consumer price index (CPI) rose by 1.2 percent in September. However, the stock market virtually ignored this inflation-warning signal with the Dow rising by 71 points and the S&P 500 increasing by 18 points. While investors continue to discount the likelihood of significant and rising inflation in the economy, members of the Federal Reserve Open Market Committee (FOMC) maintain their position that the real danger to the U.S. economy is inflation and that higher interests rates is the needed tonic. Who is correct investors or the FOMC?

While the overall CPI for October did increase at the highest rate in 25 years, the core rate, which excludes food and energy, increased by only 0.1 percent indicating little reason for concern. But the Fed must act preemptively and guard against budding inflation. So does there appear to be rising inflation in the pipeline? Very few economic indicators point to inflation problems.

For example, the 5-year inflation indexed U.S. Treasury note showed an estimated inflation rate of 1.64 percent on October 7, 2005, but up from 1.24 percent a year earlier. But neither reading should produce the angst that the FOMC expressed in minutes from their September 20 meeting.

Moreover, the 10-year U.S. Treasury rate, which prices in what investors expect for inflation stands at 4.4 percent, virtually the same as the rate one year earlier and down from 2001’s 4.99 percent. In 2001, the Fed was actually concerned with deflation and was pursing a policy of reducing short-term interest rates.

Finally, the University of Michigan’s expected inflation rate stood at 3.1 percent in August 2005 and up from 2.8 percent one year earlier. However, this rate was 2.7 percent in 2001 when the real concern for the economy was deflation. This indicator has consistently overstated inflation over the past decade.

Thus despite statements from the minutes of the last meeting of the FOMC indicating substantial inflation concerns, investors across the globe disagree. Who is correct? Look no further than May of 2000 to find evidence of the Fed’s inflation miscalculations. That month, the FOMC raised short term interest rates by 25 basis points only to reduce them by 50 basis points less than 8 months later on January 3, 2001. I think global competition and moderating oil prices in the months ahead will restrain inflation well below the Fed’s expectations.


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