Core Inflation Is a Growing Threat to the Economic Expansion

Wednesday, June 07, 2006

The extended period of above-trend GDP growth and the associated shrinkage of slack in U.S. labor markets have generated growing concern on the inflation front. The Fed is quite worried about upward pressures on “core” inflation (excluding prices of food and energy) from tightening labor markets as well as from soaring energy prices that inevitably have been making their way into the core through business cost structures.

Core inflation readings for the first quarter of 2006 were reasonably well contained, at least on a year-over-year basis, although various measures definitely firmed up on a quarter-to-quarter basis. Furthermore, available data for April show further acceleration.

The core consumer price index (CPI) definitely is on an upward path, showing annualized increases of 3.6% in both March and April, and the April reading was up by 2.3% on a year-over-year basis — not far below our estimate of the upper bound of the Fed’s tolerance zone for this inflation measure (2.5%).

The Fed’s favorite inflation gauge, the core price index for personal consumption expenditures (PCE) rose at an annual rate of 3.0% in April and was up by 2.1% on a year-over-year basis — slightly above our estimate of the upper end of the Fed’s tolerance zone for this measure (2.0%).

The evolving slowdown in economic growth, and the associated loosening of the labor market, should relieve upward pressure on core inflation before long. We expect the key PCE price index to drift back within the Fed’s tolerance zone by late this year.

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