Wednesday, February 20, 2008

Accelerating Inflation

Yesterday's closing price of oil over $100 a barrel was noticable as a psychological marker of increased inflation. Some of this price increase may have been driven by the refinery fire in Texas, a bit more from the discombulation of the global supply chain as Exxon is not able to buy Venezualan oil and buyers need to shift their purchase patterns, more concerns about Iraq and Nigeria and insurgent groups cutting pipelines again. But as James Hamilton at Econbrowser notes, oil is just part of a general inflationary trend:

On the same day that crude oil gained 4.8% in price, gold was up 2.6% and copper shot up 5.8%. The latter in particular could have little to do with geopolitical events in Venezuela, Nigeria, Iraq, or any other scary place, but instead seems better accounted for by the following:

Copper rose beyond $8,000 a ton in London to a four-month high on speculation that China, the world's largest user, will import more of the metal. Aluminum and lead also climbed....

Copper has risen 21 percent this year as demand from China is forecast to expand 11 percent in the first quarter, following last year's 17 percent jump.


Today the Department of Labor is reporting that the entire CPI increased 4.1% year over year, and the core rate increased by about 2.5%. Both of these levels are significantly outside the Federal Reserve's comfort zone. The Fed ideally would target core inflation to be a little less than 2.0%. In normal times, a couple of months with these types of readings would prompt the Fed to start raising short term interest rates to maintain their inflation fightin credibility, but I don't think that the Fed or anyone else (myself included) believes that these are normal times. Bloomberg notes that inflation seems to be accelerating concurrently with the slashing of interest rates:

Compared with a year earlier, consumer prices rose 4.3 percent, after a 4.1 percent gain in December. The core rate was up 2.5 percent from January 2007, the biggest jump since March 2007, compared with a 2.4 percent increase the previous month.



Barry at the Big Picture has a great graph that is showing the CPI components and how they have been performing year over year, and with two metrics of recent changes.


All Items are showing inflation accelerating in the past couple of months. The biggest driver is the accelerating inflation in transportation costs which absolutely dwarves any other category's changes. The only area which is showing very low inflation is Recreation, which is overwhelmingly dominated by discretionary spending. There is no pricing power there which strongly suggests people are pulling back from optional 'fun' purchases as spending power is being shifted towards intermediate term fixed costs.

Inflation is accelerating, interest rates are dropping and are projected to continue to drop. Right now the Cleveland Fed's model is projecting at least a 70% chance (eyeballing it) of the Fed Fund rate dropping from the current 3.0% to 2.5% at the March meeting. There is 98% to 99% probability of at least a quarter point cut.



Bailing out the fiscal system with low interest rates and liquidity will produce accelerating inflation. I'm not complaining too much as long as my wages can keep up with inflation as most of my debt is fixed rate debt, but I am glad that I am not a central banker right now.

NB: If we continue to see accelerating inflation over the next year or two, the snap-back model of a Fed (controlled by a conservative inflationist in Bernacke) seeking to regain its inflation fighting credibility could pull a Volker, ratchet up rates, destroy inflation, and throw the 2012 election to a challenger. But no, we know that the Fed is never political [/illusions]