Price Inflation Up 6.4%
by Brian Wesbury and Robert Stein
Issue 140 - September 30, 2009

After taking a month off in July, consumer prices were up 0.4% in August (0.447% unrounded). The gain in prices was primarily due to energy. In particular, gas prices increased 9.1%. Consumer prices are down 1.5% versus last year but this number is misleading. Commodity prices dropped rapidly late last year as the economy fell off a cliff and into a panic. So far this year, consumer prices are up at a 2.7% annual rate.

In the past three months prices are up at a 4.9% rate. “Out-of-pocket” inflation has been even higher than these figures suggest. About 24% of the CPI consists of “owners’ equivalent rent,” which is the government’s estimate of what homeowners would get for their homes if they rented them out. This estimate of rent has been very subdued lately. But remember, no homeowner actually pays this money to anyone. Excluding imputed rent, the CPI is up at a 3.1% annual rate so far this year and a 6.4% rate in the past three months.

Month-to-month data can be volatile, so not every month will show accelerating inflation, but with the Federal Reserve still implementing the loosest monetary policy in peacetime US history, we believe the underlying trend will remain upward. In the past year, real (inflation-adjusted) average hourly earnings are up 4.5%. If inflation is not arrested soon, it will increasingly rob workers of their wage gains, converting nominal wage increases into flat or negative movements in real wages.

Whether inflation moves higher after that is an open question. And the answer depends on how quickly the Fed unwinds its unprecedented liquidity injections.

Some of this exit strategy is relatively simple – with the Fed letting its exotic lending facilities wind down. But sooner or later, the Fed will need to use traditional tools – withdrawing money from the system (or slowing its growth sharply), and allowing interest rates to rise.

Right now, despite much stronger economic data, the Fed is intent on keeping rates where they are for an “extended period.” The Fed has no desire to raise rates this year as it fights what it believes could be Great Depression II. We think this is a mistake. The economy is bouncing back rapidly in a V-shaped pattern. And the sooner the Fed lifts rates, the less inflation (and more economic stability) the US will have down the road.

We project that in the second half of this year, nominal GDP will grow at about a 6% annual rate, with four points from real GDP growth and two from inflation. (The GDP deflator should grow more slowly than CPI inflation as import prices increase faster than export prices.) In 2010, because of past monetary ease, nominal GDP will be growing even faster. In this environment, the federal funds rate should be significantly higher than it is today – a 5% rate would not be too tight.

While this probably took the breath away from some readers, it is important to remember that higher rates do not, by themselves, have to mean a quick end to the economic recovery. The federal funds rate was 8.5% in late 1982 as the US started emerging from the brutal recession of 1981-82. Eighteen months later the federal funds rate was 11.5% and yet the economic recovery powered on even as many banks and S&L’s failed due to the bursting of the 1970s inflation bubble.

Granted, the Reagan tax cuts and de-regulation helped the economy grow without artificial monetary stimulus in the 1980s. And it is also true that fiscal policies these days are not designed to boost growth. But loose money is never a good long-term stimulant. In fact, the longer it takes the Fed to move toward the exits, the more damage will be done and the harder it will become to exit at all.

Brian S. Wesbury is Chief Economist and Robert Stein, CFA is Senior Economist at First Trust Advisors

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