Are We At The Upper Range For “Safe” Inflation?

For the second consecutive month, consumer price inflation rose by 0.5% last month on a seasonally adjusted basis, the Labor Department reports. That’s the highest monthly rate in nearly two years. Higher energy and food costs are the key drivers for the higher inflation. In a world where inflation is bubbling around the globe—in China and India, for example—today’s news on U.S. inflation can’t be dismissed. But neither should today’s U.S. numbers be overstated.

Although the consumer price index (CPI) rose at a relatively high pace last month, it’s still well within the range we’ve seen in recent years. Meanwhile, core inflation (CPI less food and energy prices) actually dipped in March. Unless you’re expecting a sustained rise in food and energy prices from here on out, then there’s a case for arguing that inflation’s not set for a dramatic upside breakout.

Let’s keep in mind too that monthly CPI numbers can be misleading if we’re trying to get a handle on what’s coming in the next several years. That inspires reviewing the longer-term trend instead. On that front, rolling 12-month changes in headline and core CPI still look quite modest in terms of the ranges for the past decade, as the second chart below shows. But let’s be clear: the margin for comfort is fading for tolerating ongoing increases from current levels.

That brings us back to commodities, the primary source of the recent pop in inflation in recent months. To some extent, the higher inflation is healthy because it represents a rebound from the deflationary pressures of the recent past. But too much of a good thing can turn ugly… eventually. The bottom line: the rise in commodities prices will keep everyone wary until it stops and/or reverses.
History suggests that the rising commodities prices of late will cease and desist at some point. Indeed, the long-term expected return on commodities is more or less zero, and for good reason. But commodities are a volatile lot and in the short-to-medium term there’s ample opportunity for sustained price momentum. Nonetheless, numerous studies show that forecasting inflation tends to benefit from looking at core inflation readings, but that’s always a questionable affair in real time, especially these days, when political volatility in the oil-rich Mideast is roiling confidence about future supplies of crude.
A number of analysts say that much of the rise in energy prices is due to the temporary influence of speculators. Perhaps, but there may be fundamental reasons for the higher oil prices as well. A research report today from Neil Beveridge and Liang Zhang at Bernstein Research focuses on this point by noting that OPEC’s global spare capacity has dropped sharply this year.
“The elimination of Libyan exports effectively takes us back to the same spare capacity levels last seen at the start of 2008,” the Bernstein analysts write. “How permanent this disruption will be is impossible to predict, although damage to Libyan oil infrastructure suggests that even in the event of hostilities ending it will take some time before exports are fully restored to pre-war levels.”
It seems that we’re at a critical juncture for inflation. The market’s forecast for inflation, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, inched higher to 2.62% as of yesterday. That’s a hair above the previous peak set back in July 2008, on the eve of the financial crisis and during the all-time high in oil prices. That raises the question today: Are inflation pressures set to roll higher? Or will the cyclical aspect of commodities prices save us at the 11th hour? No one can be sure either way, which is why the coming weeks and months may be precarious.
The risk is that the Fed is forced to raise interest rates prematurely. That may please inflation hawks, but the potential for trouble is clear. The nominal Fed funds rate is still close to zero, yet the outlook for economic growth is still modest, at best. Higher interest rates aren’t likely to to boost GDP projections, and tightening may even pare expectations by more than a little. We’re not at the rock and the hard place yet, but it’s a bit harder to dismiss the possibility.