Inflation is alive and well

I suspect a good many people would be surprised to learn that, if you abstract from volatile energy prices, consumer price inflation in the U.S. has been running at an annualized rate of 2.0% for the past 10 and 20 years. In fact, the CPI ex-energy is up 2.1% in the 12 months ended February and it has even risen at a 2.3% annualized rate over the past six months and 2.5% over the past three months. Inflation is far from dead, and the deflation concerns you've heard about in recent years are all the by-product of collapsing energy prices, which, by the way, are now a thing of the past.

The FOMC undoubtedly will take note of this fact in their deliberations today, and it will encourage them to move—albeit slowly—to raise short-term interest rates to a higher level. This should not be surprising nor scary. On the contrary, it would be scary if they ignored the behavior of core inflation.

The chart above shows the year over year change in the CPI (total) and the CPI ex-energy. Note how much more volatile the total is compared to the ex-energy version. Note also how the most recent period, during which oil prices have collapsed—is similar to the 1986-87 period, when oil prices fell about as much in percentage terms as they have in the past 22 months. In both periods, the total CPI suffered a significant decline followed by a significant rebound, while the ex-energy version was relatively unchanged. There is every reason to believe that the headline (total) CPI will register 2% year over year growth (if not more) within the foreseeable future, since oil prices are no longer declining and have even rebounded some 40% in the past month or so.

The Fed's preferred measure of inflation, the Core Personal Consumption Deflator rose 1.7% in the 12 months ended January, and it is likely to post a slightly higher rate of growth in February. This is entirely consistent with the behavior of the CPI, since the PCE deflator tends to register about 30-40 bps less than the CPI. What this means is that the Fed's preferred inflation gauge will soon be very close to the top end of its 1-2% target range.

Memo to FOMC: Raising short-term interest rates to 0.75% in the next few months—thus leaving real short-term rates still deep in negative territory—would not only be fully justified, it might even be too little too late.