Inflation Gets a Big Headstart


By Michael Englund and Rick MacDonald Talk about a head fake. Coming into the Feb. 18 release of the

producer price index for January, economists had wondered whether some statistical tweaks to the report's energy component would mute the impact of oil price swings on the wholesale-inflation gauge and result in a tame figure for the month. The PPI figures indeed revealed the January energy price restraint expected following those revisions, given the modest 0.3% overall gain for the month.

But the "core" index -- which strips out food and energy prices -- told a far different story. That index, led by a surge in tobacco prices, jolted the markets with a 0.8% surge in January following the moderate gains of 0.2% in each of the prior two months. That falls well above the median forecast of a 0.2% rise and represented the biggest monthly increase in the core index since December, 1998. More worrisome, it represented the sixth straight month of a surprisingly firm core number.

WHOPPING GAIN. Even worse headlines would have resulted were it not for new seasonal factors released on Feb. 16. They helped to significantly reduce the reported seasonally adjusted strength in energy prices. Indeed, the first-quarter inflation increase previously feared by Wall Street emerged in the January report after all, but this time the culprits were in the alcohol, tobacco, and vehicle components of the index.

The year-over-year PPI figures now reveal the largest gain in the core index since November, 1995, with a whopping 2.7% January gain, vs. increases of 2.2% in December and 1.9% in November. Note that the headline year-over-year growth figure peaked in November at 5%, the largest headline gain since big increases during 1990's August-December period, when energy prices surged in the run-up to the first Gulf War.

While the strength in the January core index will likely prove attributable to a few "one-off" factors, the data certainly raise the risk that the Federal Reserve may tighten its trajectory more aggressively than the market expects. Though we at Action Economics believe that inflation is largely under control, thanks to the steps the central bank has already taken, current Fed policy is clearly at risk as evidence mounts of the normal cyclical pressure on domestic prices in 2005.

CONSUMER PRICE IMPACT? Additional irritants to the inflation outlook will include a likely ongoing downward bias to the value of the U.S. dollar, an upward bias to oil price risk given uncertainty in the Middle East, and the accumulated effect of a prolonged stimulative period of monetary accommodation.

We'll wait to see how much of this unexpected surge in January's core rate translates into the

consumer price index report for the month, scheduled for release Feb. 23. Then we'll decide how much of a problem inflation is for the Fed -- and whether this will be enough to get the Federal Open Market Committee, the Fed's policymaking arm, to drop references to "measured" rate hikes in favor of something stronger. Englund is chief economist and MacDonald global director of investment research and analysis for Action Economics


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