July 18, 2007
BETTING ON CORE
Inflation, the government reported this morning, was running at an annual pace of 2.7% through the end of June. That's near the fastest rate posted so far this year, falling just short of the 2.8% increase in March.
Granted, 2.7% by itself is nothing to lose sleep over, as headline rates of inflation go. But it's the upward bias that concerns us. After dropping precipitously in the second half of 2006, inflation has proven itself resilient in bouncing off the low-1% range that briefly triumphed last October, as our chart below shows.
Of course, the Fed looks to core inflation as the superior measure of inflationary trends. The reasoning is that by stripping out the statistically noisy elements of headline inflation (i.e., food and energy), a core reading of pricing trends offers a superior tool for predicting where headline inflation is headed. A number of studies conclude no less. As Alan Blinder, a former Fed vice chairman and currently a Princeton economics professor, told the Wall Street Journal last week: "The Fed is pretty powerless to do something about the price of energy or the price of food. I don't want to charge the Fed with responsibility for something it can't do."
Ok, so how does core inflation look? Judging by the latest numbers out this morning, there's reason for hope. Core CPI advanced by 2.2% for the year through last month--the slowest annual pace since March 2006. The downturn is even more dramatic if you consider that as recently as last September, when the annual pace for core ran at a steamy 2.9% rate.
Perhaps the Fed should declare victory and move on. The opportunity arises today when Fed Chairman Ben Bernanke begins two days of testimony in Congress.
But while core CPI continues to cooperate, there's growing anxiety in the forex world as the dollar shows signs of sinking further. Earlier today, the U.S. Dollar Index broke through its previous low set back in 2004. In turn, the dollar's ills have inspired the gold bulls anew. "I think there has been a little bit of improvement in investor interest in gold, David Moore, a commodity strategist at the Commonwealth Bank of Australia in Sydney, told Reuters yesterday. "I certainly think the weakening in the U.S. dollar has been a factor in that."
One factor driving the greenback lower has been the Fed's steady-as-she-goes routine with interest rates while the price of money has been rising in Europe. It remains to be seen if a further deterioration of the dollar, which implies higher inflation via imports, will be enough to push Bernanke to raise rates. The political timetable, meanwhile, suggests that any rate hike will come this year in a pre-emptive move to avoid tightening in 2008, a presidential election year.
But for the moment, there's no sign of rate hikes in the futures market, where Fed funds contracts continue to anticipate no change for the foreseeable future.
That leaves Bernanke's analysis over the next 48 hours as the next great variable to dissect. The burning question for us: does core's latest trend give the chairman comfort? We're all ears....
Posted by jp at July 18, 2007 9:46 AM
JP, the US dollar is weak, as the US basket shows, but most of the US' imports do not come from either the UK or the eurozone, but from Canada, Japan and China. Canadian exports of oiil & gas are not just priced in US dollars, but denomimated in them, as are most commodities. As we have seen the US dollar is not terribly weak against the yuan. And the US dollar is up against a globally weak yen. So does this not over-state the case for imported inflation from a US dollar that is mainly weak against Sterling and the euro (and the pesky Loonie)? Cheers.
Posted by: MrBill at July 19, 2007 8:28 AM