U.S.: Will the Real Inflation Rate Please Stand Up?

As any carpenter will tell you, you have to use the right tool for the job. In the next few months, that advice will be important for inflation-watchers. Now that the latest data confirm the recovery is strongly under way, policymakers, business executives, equity investors, and bondholders will soon shift their main topic of conversation from growth worries to future inflation.

Clearly, fears about growth are vaporizing. The data are so strong that some economists now think real gross domestic product grew as fast as 6% in the first quarter. The latest evidence: In March, consumer confidence posted the largest jump in 11 years (chart). February orders for capital goods continued to edge up, hinting that business confidence in the future is starting to turn around. And the index of leading indicators, which is designed to foreshadow the economy's path, has scored the largest four-month advance in 19 years.

Amid such robust news and expectations of coming interest-rate hikes by the Federal Reserve, it's natural for the subject of inflation to pop up. Already, commodity prices are picking up broadly. More expensive crude oil is pushing up the retail price of gasoline. And in February, the consumer price index, excluding energy and food, posted a surprisingly large 0.3% increase from January.

Expect the CPI to inch up higher in coming months for several reasons. First, rising energy prices should lift all of the price indexes. Second, businesses are trying to recoup some of the pricing power they lost after September 11. The risk is that a repeat of the surprise jump in the February CPI could cause jitters in the stock and bond markets and hasten speculation that the Fed must raise short-term rates quickly.

BUT THE OUTLOOK for inflation must look beyond a few monthly gyrations, and fears about persistent price pressures may be overblown. Indicators of future inflation, including some complex composite indexes, suggest that inflation's underlying trend this year will most likely be down. That is, core inflation, which excludes the volatile energy and food sectors (where movements are often more supply-related than demand-driven), will probably end the year lower than it is now.

That has been the pattern in the past. A recession typically allows slack to build up in the labor markets and in factory capacity. Even a strong recovery does not use up that slack quickly. As a result, inflation has always declined during the first year of a recovery.

That trend will hold in 2002, but there's a caveat that any carpenter can appreciate: How much inflation slows this year will depend on what tool is used to measure the overall price level. You can follow the CPI, reported by the Labor Dept.'s Bureau of Labor Statistics. Or you can track the Commerce Dept.'s lesser-known but increasingly important price index for personal consumption expenditures, called the PCE index.

Right now, the two gauges are flashing very different signals. The February CPI says that yearly inflation is 1.1%. The PCE index for January, the latest available data, puts it at 0.5%. The divergence in the core indexes is even more dramatic (chart). Core CPI inflation is 2.6%, and it has held close to that level for a year and a half. The core PCE index is up only 1.2%, and it has declined by almost a full percentage point over the past year. If the CPI were the only measure available, Fed officials and investors might not be so sanguine about price pressures right now.

THE CPI IS SO INGRAINED as a symbol of inflation in the minds of consumers, executives, and investors that you may be surprised to learn that the Federal Reserve abandoned it as its primary inflation gauge a few years back, in favor of the PCE index. Most economists also believe that the PCE yields a truer reading because it tracks the cost of things people actually buy as their spending patterns change when one item becomes cheaper or pricier relative to another. Capturing such product substitution makes it a better measure of the daily cost of living, they say.

The CPI, on the other hand, is based on the price movements of a fixed basket of goods and services. Although Labor's BLS now changes the items in the basket more frequently, the CPI's major shortcoming is that it still accounts for very little shifting in buying patterns. The BLS made an adjustment to capture more of these fluctuations in 1999, but only in a small way.

In August, the BLS will introduce a new, supplemental CPI that will be calculated more like the PCE index, allowing it to include even more product substitution. Although experimental, this is a big step for the BLS, which had previously said that the CPI was not designed to be a cost-of-living index. The BLS has made several other improvements in the CPI since the 1996 Boskin Commission report to Congress, which concluded that the CPI overstated inflation by as much as 1.1 percentage points. Economists believe that the overstatement is lower now, but still significant.

A BIG UNCERTAINTY for the interest-rate outlook is whether the bond market and the Fed will pay attention to this new CPI. But whether old or new, that index is likely to show less of a slowdown in inflation this year than will be evident in the PCE index.

That's because, product substitution notwithstanding, core CPI inflation will be bolstered by the services sector, in which two key areas--housing and medical care--are treated much differently than they are in the PCE index. Prices of health-care services in the CPI are rising at a 4.5% yearly rate, compared with only 2.2% in the PCE index. For basic housing costs, the two indexes show similar price gains of about 5%, but housing carries less weight in the PCE index. Taken together, owner-occupied housing and medical services account for 33% of the core CPI.

Medical care and housing partly explain the sharply divergent paths in the CPI measures of goods inflation and services inflation during the past year. Excluding energy and food, goods inflation is actually goods deflation. Prices have declined 0.9% during the past year, mainly reflecting the economic slowdown, the steep recession in manufacturing, and the strong dollar. However, core service inflation in February was 4.1%, and it has been accelerating steadily for two years, from 3.6% a year ago and from 3% two years ago (chart). Service inflation in the PCE index looks much tamer.

So is the CPI superfluous? Not really. Economists agree, the more information, the better. And the CPI is still used to determine Social Security adjustments and many workers' pay and benefits.

The Fed's apparent endorsement of the PCE index probably gives it the edge as the inflation measure of choice for policymaking and investing. And with the BLS' introduction of its new supplemental index in August, it would appear that even the CPI is slowly aligning itself with its crosstown competitor. By James C. Cooper & Kathleen Madigan

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