US Inflation: Does it Matter?

I took a look at some recent data and I can see why some feel that inflation isn’t a major concern right now. Two major accounts, the Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE), suggest that inflation in the US is not yet a problem. Remember that the Fed has set its target inflation band from 1.5% to 2.0%.

In case you didn’t know, the US’s annualized inflation, as measured in the CPI, stood at 1.84% in November which was well within the central bank’s target range. On a monthly basis, the headline inflation figure only grew by 0.4% while the core version of the report, which excludes energy and food prices, did not register any gain at all.

Meanwhile, the latest PCE also showed the same thing. In fact, the core version of the PCE report even fell to 0.0% from 0.2% during the same period. Take note that the Fed prefers the PCE over the CPI because it incorporates data from the current period and the preceding period. More than that, it takes into account the demand for product substitutes.

Note that the US business cycle generally peaks from November to January, mainly due to the Thanksgiving, Christmas and New Year holidays. But from the monthly figures stated above, we can only deduce that the small jump in inflation was due to a rise in energy prices and not because of a surplus in demand. For your information, oil prices rose to about $76.00/barrel by the end of November 2009 from $69.95/barrel during the start of October, a gain of about 8.6%!

Weren’t people supposed to be shopping around this time in preparation for the holiday season?

Still, other data, like the Producer Price Index (PPI) report, suggest that inflation is starting to pick up. November’s report showed that the price of goods and services sold by manufacturers increased by 1.8%. This was higher than the 0.8% rise initially predicted, and followed up a 0.3% increase from the previous month.

Import prices have also risen in the last four months, hinting that this coming Friday’s CPI release could possibly come out better-than-expected. The most recently released report on import prices revealed a 1.7% jump in November, up from October’s positively revised 0.8% rise and higher than the 1.2% expected increase.

Well, the results of these reports tend to be a little volatile so I’m sure they’re hardly an indication of future inflation! But with the country’s debt reaching into the TRILLIONS since getting slumped in the global recession, the prospect of inflation (which essentially causes the dollar to lose some of its purchasing power) is well within the horizon.

Now, if you’ve been paying attention to the news, you’ll know that many creditor nations of the US, namely China, have been diversifying out of the dollar. It’s no secret: inflation can be the Fed’s magical tool to topple America’s mountain of debt. Remember, since inflation reduces the purchasing power of the dollar, it will make the country’s debt worries more controllable. Inflation effectively erodes the real value of debt while improving the country’s debt to GDP ratio at the same time. On the other hand, an unprecedented rise in price levels could also hurt US consumers, who are already plagued by worsening labor market conditions.

Now, when it comes to the bank’s inflation forecasts, the Fed seems to be divided. Some FOMC officials believe that the current slack in the US economy could keep a lid on price levels while others warned that the Fed’s failure to promptly withdraw their easing policies could soon pump up inflation. Despite their differences in opinion, the policymakers agreed that monetary policy should be responsive to any significant changes in the economy.

Ultimately though, whatever moves the Fed decides upon will have a direct impact on sentiment on the dollar. Last December, once signs of progress popped up in different sectors of the US economy, the Fed hinted that there was the possibility that interest rates could be raised earlier than expected. This led to the surprising dollar rally that capped 2009.

If inflation is to rise sharply, it could give rise to speculation that the Fed could choose to tighten its accommodative monetary policy to mop up the excess liquidity in the market, which could once again spur some dollar buying. On the other hand, if prices remain steady, we may see the Fed keep their “wait and see” approach, which could prompt traders to search for higher yielding assets.

So I repeat: Does inflation matter right now? Yes it does!