Low Core Inflation Numbers Encourage Fed to Maintain Policies

Despite a rise in cost of living, low core inflation numbers are encouraging the U.S. Federal Reserve to maintain its policies on keeping interest rates near zero and …

Despite a rise in cost of living, low core inflation numbers are encouraging the U.S. Federal Reserve to maintain its policies on keeping interest rates near zero and continuing quantitative easing. However, economists warn economic growth will require raising interest rates in order to combat inflation. See the following article from Money Morning for more on this.

Even though the cost of living in the United States jumped higher in December, the way the government calculates inflation will give the U.S. Federal Reserve enough cover to maintain its loose money policy.

The consumer price index (CPI) rose 0.5% in December, the largest increase in 18 months, the Labor Department reported Friday. About 80% of the increase was due to an 8.5% rise in the gasoline index, also the sharpest increase in 18 months. Food prices rose by 0.1% in December.

The CPI is the broadest of three monthly price gauges from the Labor Department, because it includes goods and services. Almost 60% of the CPI covers prices consumers pay for services ranging from medical visits to airline fares and movie tickets.

But while Americans were feeling the pain of price increases at the pump and elsewhere, the Fed will maintain its focus on the so-called "core index," which excludes food and fuel prices. The core index in December edged up just 0.1% from a year ago, making for the smallest December-to-December increase in the history of the index, which dates to 1958.

For all of 2010, consumer prices rose 1.5%, down from 2.7% in 2009. Economists projected a 1.3% rise, according to the median estimate of a survey conducted by Bloomberg News.

The core inflation number is low enough to allow the central bank to maintain a steady course, keeping interest rates near zero and continuing with the latest round of quantitative easing.

"Inflation pressures remain relatively subdued because there’s so much slack in the economy," John Herrmann, a senior fixed-income strategist at State Street Global Markets LLC in Boston told Bloomberg. "It’s another factor that justifies the Fed’s stance."

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The Federal Open Market Committee left its target for the benchmark interest rate unchanged at a range of zero to 0.25% on Dec. 16 and said the labor market is stabilizing. The Fed also repeated its pledge to maintain "exceptionally low" interest rates for an "extended period." Fed policymakers next meet Jan. 26-27 in Washington.

The Fed must consider inflation as part of its mission of "conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates."

Limited inflation and a weak labor market have allowed Federal Reserve Chairman Ben S. Bernanke to stick to his plan for additional economic stimulus. But by excluding the cost of volatile fuel and food prices from its core inflation formula, the Fed is ignoring the everyday cost of living typical for American consumers. And Bernanke and the Fed may be forced to confront these distortions sooner than they’d like.

The CPI could surge much higher this year as prices for commodities like oil and grains have risen sharply in recent months. Grain prices last week hit a two and a half year high after the government said corn, wheat and soybean harvests would come in below previous estimates. Oil prices, meanwhile, have risen due to strong demand in fast-growing emerging economies.

Furthermore, companies could soon be forced to pass on some of the higher raw material costs for commodities like copper and cotton to consumers.

The Fed in its Jan. 12 Beige Book survey of economic conditions in its 12 regional districts cited comments by both retailers and manufacturers that costs were rising, but indicated that "competitive pressures had led to only modest pass-through into final prices."

Even still, the clock is ticking, say some economists.

Economic growth will force the Federal Reserve to raise its benchmark interest rate to 3% by the end of the year to combat inflation, according to Stephen Stanley, chief economist at RBS Securities Inc. in New York.

"I don’t think the Fed is ready to own up to that," Stanley said Jan. 7 in an interview on Bloomberg Radio. "Inflation will start to tick up again as we get stronger growth."

By focusing on the core inflation rate, the Fed is unlikely to acknowledge rising prices are a problem until it’s too late.

Bernanke told Congress last week that inflation would "likely to be subdued for some time."

That comes as no surprise to Money Morning Contributing Editor Martin Hutchinson, who said in a recent column that the Fed would be slow to pull the trigger on raising interest rates.

"Federal Reserve Chairman Ben Bernanke will almost certainly resist this inevitability, fudging figures and producing spurious arguments to avoid making the right decision," Hutchinson wrote. "When the Fed does eventually raise rates, it will do so grudgingly – as it did during the period from 2004 to 2007."

In fact, the Fed would like to see prices rise a bit faster than they currently are. Its preferred range for the core consumer index is 1.5% to 2%. Figures below that carry the threat of deflation in the central bank’s view.

Fears of deflation arose last summer, after consumer prices dove for three straight months. They have risen for six straight months since then.

This article has been republished from Money Morning.

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