Inconsistent Market Response to Inflation

The PPI released this morning showed headline inflation much below forecast, due to falling energy prices; but core PPI was higher than forecast. Stock futures markets rallied on the news. This is completely inconsistent with prior month's releases, when the markets rallied on relatively high headline readings because core inflation was at or below expectations.

It would seem that greater than expected PPI inflation, which also remains above the Fed's supposed comfort range of 1-2% year-over-year, would lessen the probability of the 50 bps rate cut the market's been hoping for.

UPDATE: It appears that some or all of the futures rally could be attributed to Lehman's earnings report. Even so, the PPI report didn't evoke any negative reaction.

Explaining the CPI-U

This Monday's Outside the Box E-Letter by John Mauldin features a great publication from the Congressional Budget Office. To whet your appetitie, here's the introduction:

This week in Outside the Box we look at a Congressional Budget Office publication that dives us the details on how the consumer price index for all urban consumers (CPI-U) is created. This is, as the CBO posits, the best-known official measure of inflation.

The brief that follows will venture to explain the methods used to construct the CPI-U, and how and why the index's estimates of inflation might differ from a consumer's perceptions of price changes. Though I think this article may be somewhat akin to discovering what components comprise the makeup of sausages (knowledge that is usually best left undiscovered), it is useful to understand just how the inflation data is constructed. Some of the points they make are controversial, especially when it comes to "hedonic" pricing, which they refer to as "shifts in the quality of goods and services over time." This does allow for some quite subjective influence in the inflation numbers. While I will visit this topic in a later letter, it is good to know what is and is not being measured.

Bernanke Speech : 07-10-2007

This Tuesday, Ben Bernanke spoke to the NBER-sponsored Summer Institute regarding inflation expectations and inflation forecasting. On inflation expectations, Bernanke summarized recent literature focusing on defining and measuring inflation expectations, and how to use that information to forecast and control inflation.

The more interesting part of the speech concerned how the Federal Reserve Board forecasts inflation. Rather than recapitulating the most intriguing portion, I've included it below:

The Board staff employs a variety of formal models, both structural and purely statistical, in its forecasting efforts. However, the forecasts of inflation (and of other key macroeconomic variables) that are provided to the Federal Open Market Committee are developed through an eclectic process that combines model-based projections, anecdotal and other "extra-model" information, and professional judgment. In short, for all the advances that have been made in modeling and statistical analysis, practical forecasting continues to involve art as well as science.

The forecasting procedures used depend importantly on the forecast horizon. For near-term inflation forecasting--say, for the current quarter and the next--the staff relies most heavily on a disaggregated, bottom-up approach that focuses on estimating and forecasting price behavior for the various categories of goods and services that make up the aggregate price index in question. ... In making very near-term price forecasts, the staff also uses diverse information from a variety of sources, such as surveys of prices of gasoline and other important items, news reports about price-change announcements, and anecdotal information from our business contacts. Conceptually, one might think of this effort to distinguish transitory from persistent price changes as a more nuanced way of estimating the underlying inflation trend, analogous to the trend measures provided by more mechanical indicators such as trimmed-mean or weighted-median inflation rates.

An accurate forecast of very near-term inflation is important not only for its own sake but also because it provides a better "jumping-off point" for the longer-term forecast. Because inflation continues to exhibit some inertia, improved near-term forecasts translate into more-accurate longer-term projections as well.

For forecasting horizons beyond a quarter or two, detailed analyses of individual price components become less useful, and thus the staff's emphasis shifts to inflation's fundamental determinants. Food and energy inflation are forecasted separately from the core, using information from futures prices and other sources. However, forecasts of core inflation must take into account the extent to which food and energy costs are passed through to other prices.

In addition to the above, Bernanke notes that the Board uses a range of econometric models to forecast inflation at longer horizons. However, the models' estimates are not so robust as to permit sharp inferences, so the Board's long-term forecasts "inevitably reflect a substantial degree of expert judgment and the use of information not captured by the models." Finally, he turns to the Board's use of inflation expectations in forecasting inflation.

Worthless Headline of the Day

CNN's Money site wins today's Most Worthless Headline of the Day award with this link on their homepage: Prices up in latest inflation read. Really, you don't say? Whoever wrote that must have a firm grasp of the blatantly obvious.

To be fair, that's the link displayed on their homepage, not the actual headline of the article.

Is Inflation Moderating?

Beginning with the March, 2007 FOMC statement, the Fed has stated that its primary concern is that inflation will not moderate as expected. The FOMC statement and minutes from the May, 2007 meeting and a CNBC interview with Chicago Fed President Michael Moskow on Friday reiterate this concern.

This suggests the inflation measure(s) the FOMC consults when determining monetary policy are at the upper end of their (collective) comfort range. The two charts below (click for larger image) show headline/core CPI and PCE inflation from 2000 to the present. Contrary to traditional headline/core inflation measures, the core inflation measures created by two regional Federal Reserve Banks show that inflation has not fallen from its levels of 2005 through early 2006.



Both year-over-year CPI and PCE headline inflation have decreased significantly from their levels of 2005 through early 2006. Compared to the same historical period, both measures of PCE core inflation have barely budged, and all measures of CPI core inflation have risen.

Both the PCE less Food & Energy and the Dallas Fed's Trimmed Mean PCE inflation measures have declined slightly since their respective peaks in late 2006. The Trimmed Mean PCE has fallen slightly less, however. Also worth noting, the spread between PCE less Food & Energy and Trimmed Mean PCE seems to be a pretty steady 20-30 bps.

CPI inflation is more interesting. CPI less Food & Energy inflation has fallen from its late-2006 peak of nearly 3% to less than 2.3% in April, 2007. However, 16% trimmed mean inflation has only fallen from 2.9% to 2.75% over the same period. Further, median CPI inflation remains near its levels (3.5%) of late 2006.

Moskow said, "The last quarter, GDP growth was very low – six-tenths of a percent. That’s history now. This quarter should be much stronger and, as we move through this year into next year, I see us moving toward potential growth, or long-term trend growth, in the economy." But if productivity continues falling and wage growth continues accelerating, I'm not sure what the Fed expects will contain inflation pressures. Then again, maybe that's why the FOMC's primary concern is inflation failing to moderate as desired...

I'll provide an update when May's CPI data come out on 6/15.

Inflation and the Fed

In this morning's commentary on The Big Picture, Barry Ritholtz writes:

Of course, many pundits, traders and investors -- and a goodly part of the Federal Reserve -- have convinced themselves that there really wasn't any inflation, ...

I agree with Barry regarding the many pundits, traders, and investors that have convinced themselves that there really wasn't a reason to worry about inflation (just look at the stock market action of the past few months), but I disagree that many Federal Reserve policy-makers are not concerned about inflation.

I know I've said it before on Barry's blog, but I'll say it again here: I worked at a Federal Reserve District Bank in 2004-05 as an economic research analyst - assisting the economists with their research.

There was much discussion regarding the measurement error of core CPI beginning in early 2005. That's about the time the Cleveland Fed came out with their median CPI measure, and the Dallas Fed - whose head of research is mentioned in Barry's post - created their trimmed mean PCE measure. Furthermore, the FOMC minutes have stated for some time that the main concern of the Fed is that inflation will fail to moderate as expected (i.e. inflation - by whatever measure they're now using - is above their comfort zone).

I'm not aware of the evidence Barry has seen that suggests that a good part of the Federal Reserve have convinced themselves that there is no inflation. One could argue that - given inflation data - the Fed should raise rates, but this is what is discussed/argued in FOMC meetings.

UPDATE:
Here's an interesting excerpt from the Reuters article referenced in Barry's post:

On the other hand, Rosenblum said that because the Fed relies on a number of different measures of price pressure, there was not much risk the flaws in core inflation would translate into a policy mistake.

"The fact that core is misbehaving now because food and energy are moving in one direction instead of up and down is not all that troublesome to me because we have the good sense to look at the wide range of indicators out there," he said.

FOMC Minutes : 05-09-2007

I think the following paragraph is the largest take-away from the FOMC minutes released this afternoon (all emphasis mine).

In the Committee's discussion of monetary policy for the intermeeting period, all members favored keeping the target federal funds rate at 5-1/4 percent. Recent developments were seen as supporting the Committee's view that maintaining the current target rate was likely to foster moderate economic growth and a gradual ebbing in core inflation. Members continued to view the risks to economic activity as weighted to the downside, although with turmoil in the subprime market appearing to have remained relatively well contained and business spending indicators suggesting a more encouraging outlook, these downside risks were judged to have diminished slightly. Members agreed that considerable uncertainty attended the prospects for inflation, and the risk that inflation would fail to moderate as desired remained the Committee's predominant concern.

I'm anxious to see how Fed Funds Futures will react to this release.