Core Consumer Prices – An Overview
The Consumer Price Index (CPI) for October is scheduled for publication on November 16 and the personal consumption expenditures chain price index excluding food and energy (the FOMC’s preferred inflation measure) will be published on November 30. The FOMC meeting is on December 12. Core inflation is the main focus of the Fed, for now. The Consumer Price Index fell 0.5% in September putting the year-to-year increase at 2.1%. The recent high of the year-to-year increase in the CPI was 4.3% in June 2006. Lower energy prices have helped to bring down the all-items CPI. The core CPI moved up 2.93% on a year-to-year basis in September, up 95 basis points from a year ago and the highest since January 1996.
In September, the overall personal consumption expenditure price index dropped 0.4% largely due to lower energy prices. The core personal consumption expenditure price index excluding food and energy advanced 0.2% during September, putting the year-to-year gain at 2.42%, down from 2.48% in August.
These elevated readings of core inflation are the cause for all the anxiety about inflation even in a situation when the economy is projected to be on a below potential GDP growth path for several quarters after two quarters of real GDP growth below 3.0%. An unchanged federal funds rate at 5.25% on December 12 is the most likely case. Minutes of the October 24 FOMC meeting, to be published tomorrow, will give additional insights about the FOMC’s latest views. Recent economic reports for the most part highlight weak economic conditions. This week’s retail sales numbers (to be published on November 14) and inflation data will play an important role in how the policy statement of December 12 will be crafted. If retail sales are as soft as projected, core inflation shows signs of peaking, and employment data for November are on the weak side, the policy statement could indicate the Fed’s return to a neutral posture. On the other hand, if core inflation marches higher, tough talk about inflation and an unchanged federal funds rate will prevail.
Japan: Does Another Weak Indicator Imply Soft Q3 GDP?
Last Friday the report on September private machinery orders gave Tokyo markets another reason for concern about a slowing economy and about the timing of the Bank of Japan’s (BoJ’s) next rate hike. Core machinery orders (orders less ships and electric power, a closely watched indicator of economic health) dropped by 7.4% from August and by 1.5% from September 2005, both well short of market expectations. This, the third consecutive month of year-on-year contraction in the key indicator, generated concern that the current economic softness might be the prelude to a more prolonged slowdown, and also gave the bond market reason to believe the BoJ would postpone its next rate hike until Q1 2007. While we agree that production is losing momentum, we are not ready to write off the central bank’s willingness to tighten.
We place a fair amount of value on the core machinery orders report, but not in the same way the markets do. While traders tend to study the indicator as a coincident indicator – implying the soft September figures will be fully expressed in the November 14th release of Q3 GDP, we utilize this series as a leading indicator. Under our assumption, the very weak orders numbers for Q3 as a whole will not be truly realized until the end of this year. Q3 GDP will reflect the effects of Q2 core orders which, as the previous chart indicates, came out pretty strong before the summer lull. If this leading indicator approach does show up in the next GDP report, the market consensus of a 0.2% quarter-on-quarter rise in Q3 GDP will seem quite pessimistic.
The leading indicators we incorporate into our economic model all suggest that Q3 GDP will be above expectations – quite significantly, if the numbers hold true. While the figures generated by our model do seem wildly optimistic – 1.0% quarter-on-quarter growth and 3.0% growth on the year – the direction of the model is more significant in the near-term. Not only is Q3 growth important, but take note at what happens in Q4. The slowdown everyone is concerned about rears its ugly head, with year-on-year growth decelerating a full percentage point. Again, the exact figures may be off by a little bit here and there, but the direction of GDP growth does not look good for end-2006.
The volatility of the national accounts and the timing of the data releases could work to the detriment of monetary policy between now and the December meeting. An above-consensus GDP report on November 14th would come just before the two-day BoJ meeting, and could provide policymakers with enough motivation to start prepping the markets for a December rate hike (a November rate hike is highly unlikely, as several BoJ members have spoken at length about the need to signal the central bank’s intentions to avoid yen volatility). By the December meeting there would be another month’s worth of indicators to review, but a revision of Q3 GDP would serve as a reminder of economic strength – enough of a reminder to push through a 25-basis point rate hike. Unfortunately, the Q4 GDP report (released in mid-February) would likely undershoot expectations, and the December rate hike would quickly be brought into question as the markets start concerning themselves with the possibility of a policy-induced recession rather than a mild slowdown.
Prime focus should be placed on the Q3 GDP report released on Tuesday, and if it is above expectations (as we suggest it will be), then statements from the BoJ should be monitored closely for preparatory remarks about a rate hike – one that would not be a wise move in light of what might lie ahead.
