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Confusing Signals about US Inflation and the Economy

Author: Roger M. Kubarych
April 13, 2005
Market Eye on Nikkei Financial Daily

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The latest data on the US economy have been sending some confusing signals about the US business outlook. But you might become even more confused by reading some of the statements coming out of the Federal Reserve or from the government in Washington.

Consider the inflation situation.

Gasoline prices are up 35 cents in the past six weeks. But the Fed wrote “the rise in energy prices, however, has not notably fed through to core consumer prices.” Most people do not make the distinction between inflation and core inflation, however. Certainly, they take everything into account when forming expectations of future inflation.

One government agency calculates that average home values rose a startling 11% last year, five times faster than the overall inflation rate. But another government agency, the Bureau of Labor Statistics, maintains that the “owners equivalent rent of primary residence” –the estimate of what home-owners would have to pay themselves as landlords to rent their own houses -- went up only 2.3%. Who believes that?

There is more. Based on tax collections at the US Treasury, wage incomes are rising faster than any of the standard series on average hourly or weekly earnings. Nobody I know pays taxes on incomes they don’t get.

Almost everyone realizes that health care costs are escalating. Employers are paying about 7% higher health insurance premiums for their workers, who prefer getting benefits than more pay. Yet, the Federal Reserve’s favorite inflation gauge, the so-called personal consumption expenditure price index, uses a methodology that calculates that “medical care services” are only rising about a third as fast. That one number carries roughly 25% of the weight of the whole index, so its calculation matters a lot. My judgment is that the PCE price index is underestimating medical costs.

The Fed has been giving mixed signals about its own views on inflation. On March 22, when the Fed last raised the overnight interest rate by the same 25 basis points as in the previous six meetings, it warned that “pressures on inflation have picked up in recent months and pricing power is more evident.“ That sounded to the financial markets as a clear sign of concern.

But on April 12, the Fed published the minutes of that same meeting which conveyed an entirely different message: the inflation situation is just fine. The minutes said “… many participants stated that they expected total inflation to diminish and any rise in core consumer inflation to be limited.” Indeed, a few “saw a distinct possibility of further productivity surprises, representing a downside risk to inflation.” The minutes also reaffirmed that Fed could afford to remove monetary accommodation at a “measured pace”, shorthand for more 25 basis-point increases rather than a more forceful anti-inflation policy. Bond markets breathed easier that the Fed was not that concerned about inflation after all and promptly launched a vigorous rally.

The one thing on which Fed officials seem to agree is that US economic growth is “solid.” Certainly it seemed to be a month ago. But since mid-March a number of economic indicators raise the question of whether the economic expansion may be losing momentum.

  1. Payroll employment rose only by a disappointing 110,000 in March.

  2. Initial claims for unemployment insurance have surged to around 340,000 in recent weeks, up from the 300,000 level they had reached last winter.

  3. The US stock market has been struggling throughout early 2005. All the major indexes are down year to date.

  4. General Motors announced it was making losses from auto-making and would cut production.

  5. Consumer sentiment surveys show a slight erosion in confidence, in contrast to the persistent optimism registered in business surveys. Who’s right?

  6. Commercial construction activity fell a relatively sharp 1.2% in February.

The US economy retains considerable strengths, of course. The housing market is still bubbling. Personal consumption grew moderately in Q1 2005. Non-defense capital goods orders, excluding aircraft, are 15% higher than a year ago, assuring that business investment will make a large contribution to growth. Industrial production is expanding briskly, despite problems in the auto sector.

Maybe the confusion will be cleared up by the next set of economic reports. If not, the scattered signs of loss of momentum will need to be carefully evaluated by the financial markets as well as by officials at the Federal Reserve. Rising US inflation combined with diminishing economic growth would pose a nasty dilemma for the central bank, one that it had hoped to avoid, at least until after Chairman Greenspan retires next year.

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