U.S. Inflation in Decline?

U.S. inflation pressures have moderated in recent months. This is a critical development regarding the Federal Reserve's ability to possibly trim its key short-term interest rate later this year.

We still subscribe to the view that the next Fed move will be to reduce its federal funds rate from 5.25% to 5.00% late in the year, with a reasonable chance for a second 0.25% cut in 2008's first quarter. The rate has been stuck at 5.25% for the past 11 months.

Trust me...I recognize a statement about inflation moderation flies in the face of what you and I have paid at the gas pump and in the grocery store in recent weeks. However, the Fed's most critical inflation measures have been more financial market friendly in recent weeks.

The "Core"

The Fed focuses much more on 12-month changes in inflation than on data of one- or two- or three-month periods. The Fed also focuses more on the "core" rate of inflation, which excludes volatile food and energy costs. However, another economist noted recently that the decline in the core rate of inflation was good news "only if you don't use energy or eat food."

...touche'

Whether right or wrong, the Fed's inflation attention is focused on the core personal consumption expenditures index (core PCE) and the core consumer price index (core CPI). Fed officials actually view the PCE inflation data as better consumer inflation data than the Consumer Price Index.

The "Target"

Current Federal Reserve Chair Ben Bernanke has spoken frequently in the past about his support of inflation targeting, i.e. establishing an official inflation target range within which the Fed tries to keep core inflation. Financial markets see this as an annual target range of 1.0%-2.0%. Such inflation targeting is commonplace in Europe, where the European Central Bank is firmly committed to the same 1.0%-2.0% range.

While Fed Chair Bernanke has not formally adopted inflation targeting at the Fed, financial markets nevertheless hold his feet to the fire as if he had. In contrast, former Fed Chair Alan Greenspan did not favor inflation targeting, but preferred to largely determine monetary policy by the seat of his pants.

As noted, the two 12-month (known as year-over-year) core inflation measures have been more favorable in recent months. The core PCE's most recent 12-month rise was down to 2.1%, within striking distance of the unofficial range. In contrast, this inflation measure moved toward 3.0% over the prior 12 months. The core CPI has also behaved better, with the most recent 12-month rise down to 2.3%, versus more worrisome core inflation increases over the past 12-15 months.

Downshift

The American economy has slowed over the past year, no question. The 2.1% real (inflation adjusted) annual growth pace of the past 12 months is down more than 40% versus the healthy 3.7% real annual growth pace of the prior 12 months.

Such sluggishness is comparable to a car slowing from 55mph to a 31mph pace. Recent economic slowing should help minimize inflation pressures further in coming quarters. We expect these pressures to remain under control even as we see the economy picking up speed over the next four quarters.