Inflation: Far into the Future

With capacity utilization at a record low and unemployment continuing to rise, inflation won't be a problem for quite a while

By David Wyss and Beth Ann Bovino From Standard & Poor's RatingsDirect

Inflation has passed swine flu as the most over-hyped problem in America. Inflation always lags behind the economic cycle, and while inflation is always a monetary phenomenon, the relationship isn't a magical one. A rising money supply creates inflation through its impact on the real economy, as higher capacity utilization, lower demand, and a falling currency create inflationary pressures.

With capacity utilization at a record low and unemployment continuing to rise, inflation problems are far into the future.

The May data illustrate the current absence of inflation. The consumer price index is down 1.3% from a year ago, while producer prices are down 5.0%. Both are the biggest declines in more than a half-century.

Admittedly, much of this stems from lower energy prices—the core CPI is up 1.8% from a year ago, and the core PPI has risen 3%. But these rates are still moderate, with the core CPI right in the Fed's "comfort zone."

insulated from the market

The core CPI rose 0.1% in May after a 0.3% rise in April. The core rate is a balance between most of the goods components, which are declining, except for energy and services, which are still generally rising. The biggest year-over-year increases continue to be in health care (up 3.2%) and education (up 5.5%), both of which are largely insulated from the market. Tobacco is up 27.4%, but that reflects tax hikes more than prices.

The only other significant increase for core goods is in personal-care products, up 2.7%; this is another category that is generally immune to recession. Shelter is up 1.5%, but most of the shelter index is the implicit rent on owner-occupied housing, which is not really an effective price for most households.

An oddity in May was the sharp contrast between energy prices in the producer (up 2.9%) and consumer (up 0.2%) price indexes. Part of the difference reflects timing: Producer prices lead consumer prices, and both surveys are taken relatively early in the month. Consumer gasoline price movements are usually more muted than producer prices because of taxes and refiner and retail markups, which change slowly; gasoline was up 13.9% in the PPI, compared with 3.1% in the CPI.

unexpected dip in fuel oil and natural gas

But the real surprise in the CPI was the decline in fuel oil and natural gas (down 3.1% and 1.7%, respectively). Household operation, which includes electricity, fell 0.9%. Fuel oil was up 0.6% in the PPI, while natural gas and electricity dropped 4.7% and 0.3%, respectively.

Inflation will be a problem in the future, but only after the economy returns to normal. Because we expect a sluggish recovery, the Federal Reserve should have plenty of time to drain liquidity from the system to prevent inflation. However, politics might make this difficult because the higher level of federal debt will make the budget more sensitive to interest rate hikes.

Wyss is chief economist for Standard & Poor's in New York . Bovino is a senior economist for Standard & Poor's.

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