US core consumer prices – higher rates now guaranteed?

However, with food prices up just 0.1%, the core index, which excludes both food and energy, increased by 0.3% for the third successive month. This pushed the annual rate of change up to 2.4%, the highest since March 2005. Whilst no doubt this latest larger than anticipated rise will add to fears that rising energy costs over the past 12-18 months are beginning to feed through to underlying inflation, it is worth noting that more than half of the rise in the core index was again attributable to the “shelter” component, and in particular the way house prices are treated within the CPI.

It is a moot point as to whether the cost of owner occupation should be included within any measure of consumer prices – is spending on houses consumption or investment? Partly because of this, UK CPI (currently) excludes it, but in Europe it is included, whilst our own RPI and RPIX measures use a measure derived from house prices as a proxy for housing depreciation. However, in the case of the US, more than a decade ago Alan Greenspan decreed that the way to go was instead to compute a value for “owners’ equivalent rent” (OER), which is linked to market rental rates. This element alone now accounts for one third of the core CPI index. For much of the last 10 years, the availability of cheap credit has made owning one’s house increasingly affordable. The flip side to this is that the demand for rented accommodation has slumped, driving down rents relative to house prices. This had the effect of holding down core inflation during a period of strong house price inflation (under-recording “real” inflation). However, 16 increases in interest rates over the last two years and a rebound in bond yields have driven up mortgage debt servicing costs, reducing the affordability of housing. As a result, the demand for rented accommodation has recovered markedly in recent months (vacancy rates have plummeted), and this has driven rents sharply higher – up 5.6% at annualised rates in the last three months. Consequently, just as house prices have started to come under pressure, so the rise in core consumer prices has accelerated. To make matters worse, this “statistical quirk” is likely to have an even larger effect over the coming few months, exaggerating the true extent of underlying inflation.

Fully aware of this issue, the Federal Reserve has long since stopped relying upon the CPI ex food and energy as a guide to underlying inflationary pressures. Instead, its preferred measure is the personal consumption expenditure deflator excluding food and energy. Figures for May won’t be available until the end of the month, but whilst on this basis core prices rose 0.3% in March (the same as the core CPI), they only rose 0.1% in April, whilst the annual rate of change was lower at 2.1%. That said, the Federal Reserve will have been concerned by the pick up in the three-month on three-month annualised rate to 2.4% in April, which is right at the top end of its tolerance range. However, whilst financial markets have now concluded that a rate hike at the end of June (to 5.25%) is inevitable and have assigned an increased probability to a further tightening in August, the Fed should remember that it is not where inflation is today that ought to determine policy but where it is heading over the next couple of years. Moreover, unlike other central banks the Federal Reserve has twin policy objectives – to achieve sustainable economic growth as well as price stability – and these have equal weights. With the real economy giving every indication it is in the process of slowing, the last thing the Fed wants to do is under-estimate the lagged effects of its previous monetary tightening and inadvertently engineer a hard landing.

To sign up for an email alert when a new Expert Commentator article appears ">click here.