Growth or Inflation?

An interesting piece in the FT today highlights some of the issues I've been raising (here, and here) about central bank statements and economic realities.

As the FT points out UK retail sales for September, due on Thursday, are expected to confirm consumer survey reports of weak high street activity. The consensus forecast is for an increase of 0.2 per cent, slowing year-on-year growth rate from 0.8 per cent in August to zero. Employment data have also recently been consistently weak.

Menatime oil price rises have been pushing inflation steadily upwards.

This highlights the problem with the different 'measures' of inflation - the European HICP or 'core inflation' (less the 'volatile' fuel and food ite,s). How you feel about this in part depends on where you are looking from. Vis -a-vis the 'consumer', what they feel is the real and important rise in their expenses, as indicated by the HICP. This hits them where it hurts, in the pocket. This is certainly one extremely valid point of view. Getting through to the end of the month.

The central banker, however, has a different problem set. The issue facing the central banker is whether this year's increase in oil prices (the CPI/HICP level effect) will feed through to next years inflation in the core areas (the rate effect). This is why if you want to decide what to do about interest rate policy the core CPI is important. The fact that it is trending downwards must indicate something (the harder part of the question would be what).

So the central banker needs to decide whether those consumer expectations are valid, and hence raise rates, or whether consumers are feeling a temporary squeeze and so put rates on hold to help them get through the 'soft spot' (which post Katrina may be a rather hard 'soft spot').

I can't help feeling that those who claim the 'core inflation' readings are missing the Big Picture are rather shooting themselves in the foot here. They are, I think, concerned with the strain being placed on the low income consumer (for which well done) but by making so much fuss about the importance of the 'unadjusted' CPI they are in danger of seeming to argue for a faster pace of interest rate rises.

This would give the consumer 2005/2006 the worst of both worlds: a high real inflation rate, and extra mortgage (etc) payments to boot.

The central banker's problem is complicated by the fact that that he may well want to take into account other issues like house prices and the US current account deficit, and give all these things a relative weighting.

The FT quotes Morgan Stanley's Melanie Baker as warning that inflation could stick above the BoE’s 2 per cent target until December 2006 (this would be the knock-on year on year impact of the oil hike) and that a prolonged overshoot, lasting until the third quarter of 2008, is possible (and this would be the secondary impact problem) depending on oil price developments.

The decision set is all about how to evealuate the risk of the latter.

Meantime Brandeis economist (and former Fed research director) Stephen Cecchetti has some sound explanation of all this here (Hat Tip to Dave Altig at MacroBlog)

Cecchetti also raises the valid point that in real terms, and taking the actual US CPI readings as the yardstick (currently running at 4.7% y-o-y), with a fed funds rate of 3.75%, real rates are still negative and hence pretty 'accommodative'. But then we are in the aftermath of Katrina, and the consumer is getting the 'big squeeze'. Also if the CPI does peak, and inflation trend down even while the fed continues raising the situation could soon normalise to the target 'neutral' real rate of around 2 tyo 2.5%. In fact my advice would be to watch for the backdraft, since a much bigger problem may come with strong disinflation when there is a serious slowdown in the US economy (which isn't, btw, now).