Inflation Drilldown

Inflation flared up in November with disappointing reports on import prices, producer prices, and consumer prices. But it looks worse than it really is. A burst of oil and gasoline price increases, plus very low 12-month comparisons should be put into context.

For example, over the first 11 months of 2007, the headline CPI (with energy and food) is up 2.7 percent compared to 3.3 percent in 2006 and 3.4 percent in 2005. Chained CPI (which allows more freely for substitution effects and transaction price updates) was up 2.9 percent in 2005 and 2006, but only 2.4 percent in the first 11 months of 2007.

On a core basis, the chained CPI index is up 2.0 percent this year, versus 2.3 percent last year and 1.9 in 2005. No matter how you slice the pie, the CPI peaked in the summer of 2005, while the core measure peaked in the fall of 2006.

I continue to believe that an inverted Treasury yield curve and a rock bottom 2 percent growth in the monetary base suggest tight money and lower future inflation. Some commodities watchers dispute this and I appreciate the disagreement. Incidentally, the price deflator for non-farm business has eased to 1.5 percent over the four quarters ending in Q3 from a peak of 3.5 percent in the middle of 2005. And durable goods prices continue to decline.

But I still believe that the shape of the Treasury curve and the increase in the level of the monetary base, as well as the 5 year forward TIPS spread in the bond market, have proven to be better inflation indicators in this cycle.

The latest inflation readings are likely to have only minimal impact on Fed policy. To solve the credit crunch in commercial paper and Libor, Bernanke & Co. have much more to do in order to right the upside down yield curve.