Worrying About Inflation

Wharton professor Jeremy Siegel, author of the best seller Stocks for the Long Run, worries about mounting inflation pressures. Last week, he said in a TV interview with Bloomberg that the Fed should consider raising rates soon.

Siegel’s hardly alone in calling for the Fed to act, but so far there are few signals from the market for expecting a hike in interest rates in the near term. Fed fund futures are priced this morning on the expectation that the current zero-to-25-basis-point policy range will prevail for the foreseeable future. The January 2012 contract, for instance, is priced for Fed funds at roughly 30 basis points as we write.
The Treasury market doesn’t seem worried about inflation either. The market’s inflation forecast, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, was a modest 2.44% yesterday.

Federal Reserve Bank of Cleveland President Sandra Pianalto said in a speech today that she thinks inflation will remain moderate:

I expect the underlying trend in broad consumer prices, which is currently quite low, to rise only gradually toward 2 percent by 2013. I think several factors will keep inflation in check. One factor is the continuing slow growth in wages, which helps determine the cost of producing goods and services and, in turn, the prices set by firms. Another factor is many retailers’ reluctance to raise prices in the face of strong competition and soft business conditions

What about the rise in commodity prices that has Jeremy Siegel worried? Pianalto says the associated inflation risk is “transitory”:

Some of the most recent rise in gasoline prices reflects the dramatic recent global events that have pushed oil prices significantly higher. The natural question in these times is whether these higher prices will be enough of a driving force to cause a lasting increase in the rate of inflation. At this point, I don’t think they will, and let me explain why.

First, large increases in food or energy prices have often been balanced out over time by sharp declines. For example, in 2006, oil prices rose significantly over the first eight months of the year but then dropped in the remainder of the year. While periods of rising energy prices cause inflation to rise, the subsequent periods of falling energy prices cause inflation to fall.

Second, to cause a lasting rise in inflation, the increases in food or energy prices have to be large enough and persist long enough that they spill over and cause sustained increases in a wide array of other consumer prices. At this point, there is no evidence of broad spillover, but as a central banker I keep a close eye on this.

To assess the underlying trends in a broad array of consumer prices, my staff at the Federal Reserve Bank of Cleveland calculates and publishes an indicator known as the median CPI. This index is designed to provide a reliable measure of the average increase in a wide set of consumer prices, and it has been shown to be a superior predictor of future inflation rates. To this point, inflation in the median CPI remains very low: just 1 percent over the past year. Based on the behavior of the median CPI, I don’t expect recent rises in food and energy prices to cause broader inflation.

For the moment, at least, the market seems to agree.