The inflation rate: Price puzzle

 

Inflation figures fuel a debate over when the Fed should tighten

Mar 18th 2010 | WASHINGTON, DC | From The Economist print edition

[Greg Ip] TRACKING American interest rates is like watching paint dry. At its meeting on March 16th the Federal Reserve left its short-term rate target between zero and 0.25% for the tenth consecutive time, and, given “subdued inflation trends”, said it would probably leave it there for an “extended period”.

But just how subdued is inflation really? Frustratingly, the latest data provide ammunition for both the hawks, who question the need for extended low rates, and the doves, who don’t.

Recent swings in inflation have been largely driven by petrol prices. Stripping out food and energy, “core” inflation peaked at 2.5 in mid-2008 and has drifted down to 1.3% in February. That’s the lowest core inflation rate in six years. No surprise there: recessions leave a huge gap between an economy’s output and what it could potentially produce, robbing companies and workers of their ability to put up prices and pay.

A look beneath the surface, however, complicates the story. Dave Greenlaw of Morgan Stanley notes that one component explains all the decline in core inflation: housing. America’s Bureau of Labour Statistics measures the cost of home ownership by what someone would have to pay in order to rent the house he owns. Falling home prices and high vacancy rates are pushing rents down. Since rent and the estimated equivalent of rent for owners comprise more than 40% of the core index, this has a huge impact on the direction of core inflation. When housing costs are excluded, core inflation has actually risen, to 2.6% in February (see chart). Mr Greenlaw predicts that housing inflation will stop falling, spurring the Fed to raise rates later this year.

Paul Ashworth of Capital Economics counters that rents have slowed by more than house prices and vacancy rates can explain: high unemployment is also at work. This means, he reckons, that lower rents must reflect genuine disinflationary pressure. Moreover, he notes an anomaly working in the other direction: core inflation is being pushed up by sharply higher prices for second-hand cars, supplies of which shrank after the success of last year’s cash-for-clunkers scheme. He expects those prices to fall back and, with them, core inflation, helped by steep declines in labour costs as productivity quickens and wages stall. His firm sees the rates on hold until 2012.

Yet even Mr Ashworth admits that core inflation and wage growth have not fallen as much as the output gap and unemployment would seem to predict. The Congressional Budget Office recently reached a similar conclusion, and revised up its inflation forecast for this year.

Hawks on the Fed’s policy committee have long been sceptical of the output gap’s influence on inflation, and want to soften the pledge to keep rates at emergency lows. Ben Bernanke, the chairman, has so far resisted. The debate may be tilted by the candidates who will fill three vacancies on the Fed’s board.

The White House has signalled that it may nominate Peter Diamond, an economist at MIT best known for his research on Social Security, and Sarah Bloom Raskin, a Maryland state financial regulator and former congressional staffer, to two of the seats. Janet Yellen, an accomplished macroeconomist, would be its choice for the third seat and as vice-chairman. Though Ms Yellen, as president of the San Francisco Fed, already sits on the policy committee, her new position brings added stature and a permanent vote. She is also the Fed’s most prominent dove, and thus an influential ally if Mr Bernanke wants to keep rates where they are.

The original article is linked here.

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