Interest Rates: Still a Way to Go


By Michael Englund In recent speeches, Federal Reserve officials have continued to sound warnings on inflation. And the minutes from the central bank's Sept. 20 meeting, released Oct. 11, confirmed that rising prices remain the key worry for the majority of policymakers. The Fed and the markets will be carefully watching upcoming U.S. data releases for September for an energy-led upside jolt to key inflation gauges.

How will the energy spike play out in the month's data? We at Action Economics believe the clearest sign of the inflation consequences of this most recent spike in energy prices will be seen in the September consumer price index (CPI) report, scheduled for release Oct. 14.

ANCIENT HISTORY. We expect a solid gain of 0.8% in the overall index, with a 0.3% increase in the core index, which excludes food and energy prices. Action Economics expects a solid gain of 0.8% in the overall index, with a 0.3% increase in the core index, which excludes food and energy prices.

More notably, the year-over-year gains will likely show inflation soared 4.3% in the 12 months ended Sept. 30, from 3.6% in August, while the core year-over-year gain remains at 2.1%. The September headline rate will be the highest since July, 1991. Though some may take solace in this figure likely marking a near-term peak -- we expect a drop in this rate back to 3.7% in October -- it's clear that overall year-over-year CPI inflation is unlikely to drop below a 3%-4% rate anytime soon.

Indeed, headline inflation has consistently exceeded core inflation, according to the CPI report, since a brief reversal of fortune between October, 2001, and October, 2002, when the post-September 11 drop in energy prices worked their way through the domestic price measures.

SHRINKING GREENBACK. Before then, we have to go back to June, 1999, to find the last time that increases in overall CPI inflation have fallen short of CPI excluding food and energy. Economists often exclude food and energy prices from inflation measures because they are too volatile, not because they are too prone to outsized and persistent gains.

A similar pattern will likely be evident in the producer price index (PPI) data for September, scheduled for release Oct. 18. We expect a 1.2% September increase in PPI overall, and a 0.2% gain excluding food and energy, that will leave year-over-year inflation rates of 6.1% for the overall index and 2.4% for the core. As with the CPI, this measure also consistently reveals overall inflation that exceeds the core rate back to 1999, if we exclude the post 9-11 period, suggesting that "true" inflation likely lies between the headline and core rate, and not at the core rate alone.

One irritant to the U.S. inflation outlook is the downtrend in the U.S. dollar since its peak in February, 2002, which we believe is still in place despite the upside correction in the greenback through the first half of 2005. The major dollar indexes are all showing a resumption in the dollar downtrend that we believe will continue in 2006.

SLIPPING ON OIL. This is bad news for the import and export price indexes, for which the September data are due on Oct. 13. The trade-price data have clearly shown a powerful uptrend since the dollar assumed its downtrend in early 2002, with trade-price strength largely led by oil prices.

Interestingly, the indexes should receive only a modest boost from oil in September, as spot oil prices only rose about 1% for the month, and we expect figures in the 0%-to-0.2% area for overall and "core" import and export prices. Of note, however, is an expected large overall year-over-year import price gain of 7.3% in September, alongside a 2.7% gain in export prices.

The general strength in most domestic measures of inflation will be less noticeable in the chain-price data component of gross domestic product than the figures expected for the fourth quarter. Oddly enough, the faster rise in import prices for energy than domestic prices in the third quarter actually depressed the third quarter chain-price number at the expense of the fourth. We expect GDP chain-price gains of 2.0% in the third quarter and 3.0% in the fourth.

REAL VS. HYPOTHETICAL. But the quarterly chain-price gains are clearly showing an upward trend through this expansion, to rates of gain consistently in the 2%-3% zone -- which is above the rates generally seen in the last expansion. That's important because the chain-price data reflects what consumers and businesses actually pay for goods and services, unlike the CPI and PPI, which are measures of changes in hypothetical purchases of goods and services.

We believe September's inflation reports should confirm that trend, giving further ammunition to the Federal Reserve to continue its current tightening trajectory. We look for the Fed to raise rates by 25 basis points at its next three policy meetings, bringing the Fed funds target rate to 4.50% by the end of January.

Englund is chief economist for Action Economics


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