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Daily Global Commentary

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FOMC's Inflation Concerns Can Be Toned Down

Wed, May 16 2007, 01:30 GMT
by Asha Bangalore

Northern Trust

The Consumer Price Index (CPI) rose 0.4% in April, after a 0.6% increase in March. The energy price index advanced 2.4% and food prices rose 0.4% in April. Year-to-date, the CPI has risen at an annual rate of 4.8% versus a 2.5% increase in 2006.

The core CPI, which excludes food and energy, rose 0.2% in April compared with a 0.1% gain in March. Year-to-date, the core CPI has risen at an annual rate of 2.2% after a 2.6% increase in 2006. The price index for housing rose 0.2% in April, reflecting 0.2% gain in rent and owners’ equivalent rent. Medical care costs increased 0.4% in April after a 0.1% gain in March. The 0.3% drop in apparel prices, the steady price reading for new cars, and a 0.9% drop in airfares helped to trim down the gain in the core CPI. On a year-to-year basis, the core CPI was up 2.34% in April vs. the recent peak at 2.71% in February.

One of the primary reasons for the acceleration in core inflation in recent years was the rising trend of housing costs reflected in the upward trend of rent (rent of primary residence and owners’equivalent rent) in the shelter component. Shelter makes up 42.3% of the core CPI. Both rent of primary residence and owners’ equivalent rent appear to have peaked (see chart 2). The year-toyear increase in rent of primary residence of 4.52% in April is off seven bps from what appears to be the peak in the current cycle. At the same time, the year-to-year increase in owners’ equivalent rent has dropped 45 bps to 3.81% in April. The primary driver of the recent moderation in the pace of rent increases is the record 2.2 million empty houses and condos in the aftermath of the burst housing bubble. “Accidental” landlords are willing to offer below-market rents in order to receive some monthly income to help offset mortgage payments, taxes, insurance and, where applicable, condo assessments.

The personal consumption expenditure price index excluding food and energy, which is based on the CPI and to be published on June 1, is the Fed’s preferred measure of inflation. This price index increased 2.1% on a year-to-year basis in March, down from 2.4% gain in February. Although they have a lower weight in the PCE price index than the CPI, the moderation of shelter costs will help bring down the core PCE price index inflation toward the 2% upper bound of the Fed’s “comfort zone.”

Conclusion – The latest projected trajectory of core inflation, given the April data and soft economic conditions, allows for a diminished role of inflation in the list of FOMC’s concerns. The probability of a shift in emphasis to weakening economic conditions in the monetary policy statement of June 28 is stronger now, assuming retail sales and employment numbers of May mimic the soft readings seen in April.

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Published on  Wed, May 16 2007, 01:33 GMT