November 29, 2005
IN CORE WE TRUST?
The divergence between core and headline inflation has divided pundits for some time, on the one hand giving hope and rationalizing low interest rates, and on the other giving cause for buying gold and selling bonds. The optimists say that the relatively low core rate of inflation, which excludes energy prices, is the true measure of price trends. The pessimists say otherwise, claiming that the higher headline rate of inflation, which factors in energy, more accurately depicts the real world.
Talk, of course, is cheap, which is to say that fans of the core rate seem to have won out, at least when it comes to pricing bonds. Headline inflation, measured by the consumer price index, advanced by 4.3% for the 12 months through October, more than twice the 2.1% rate of increase for the core CPI, according to the Labor Department. Meanwhile, the 10-year Treasury yield at roughly 4.47% as we write, which is to say more or less unchanged from the end of 2003. If the core rate of inflation is used as a guide, 4.47% doesn't look at that bad.
The bottom line: headline inflation has been rising, while the core rate has stayed fairly stable at around 2% a year. If the pessimists were pricing bonds, the 10-year Treasury would carry a much larger premium over headline CPI. Sans such a premium, it seems safe to declare that the optimists have won.
Not so fast, suggests Alan Levenson, chief economist for T. Rowe Price Associates, the Baltimore-based mutual fund company. At a press conference today in New York, Levenson explained that while rising energy prices have fueled the rise in headline inflation, falling energy prices could do the same for core inflation.
As it happens, oil prices just happen to be declining these days. Although that's unlikely to last as a long-term proposition, the trend may have legs in the short run, perhaps as long as several years. If so, core inflation may be due for a climb, Levenson effectively advises. "We'll have a greater underlying inflation problem if oil falls." In that case, what might the inflation optimists think of the 4.47% current yield on the 10 year? If a low core rate inspires buying the 10 year, might a jump in the core rate spawn a bout of selling?
Oil, in any case, is falling these days. The January 2006 futures contract for crude has been slipping since late August, when it closed above $71 a barrel. At one point today, it was under $56.
Levenson explained that labor costs are the key driver of core inflation. As the price oil and other energy costs decline, the trend fuels higher consumer spending and economic growth generally, which in turn drives up labor costs.
In fact, the government reports that unit labor costs were in virtual freefall in 2004 when the energy bull market took off in earnest. Although unit labor unit costs rebounded in 2005, it was a tepid bounce, in part because energy prices continued to surge upward, or so one could argue.
Keeping a lid on unit labor costs, according to Levenson, has been central for keeping core inflation under control of late. Meanwhile, consumers have shown no modesty in spending in one form or another in 2005, oil bull market or not--a fact that's kept the economy humming in the face of any number of challenges that would trip up smaller countries. Imagine what a sustained decline in oil prices might do for Joe Sixpack's already indomitable spending spirit. Actually, you don't have to imagine. Consumer confidence soared this month as energy prices declined, the Conference Board reported today. Now, imagine what a re-energized Joe might do to the core CPI.
Posted by jp at November 29, 2005 3:14 PM
Interesting idea. One little thought process that I wonder if you've considered: Cheap Asian labor has been one of the factors that has kept unit labor costs at bay. If that continues, how could labor costs in the U.S. rise?
Posted by: David Andrew Taylor at November 30, 2005 12:58 AM
I've heard of the fears among central bankers that high energy rates may lead to so-called second round inflationary effects, where wage negotiaters see a high headline inflation rate and bid up wages, thereby adding to inflationary pressure from cost-push side.
However, Levenson hypothesis goes in the opposite direction. He seems to be saying that high energy prices could dampen wage pressure through reduced labour demand.
As a trader, this just adds to my current confusion, reinforcing my view that that the markets will remain in a state of flux for a while yet, with clear directional get-out.
I remain on the sidelines, scratching my head and trying to formulate a macro hypothesis.
Posted by: ABOBtrader at November 29, 2005 8:13 PM