June 22, 2005

The good news is that inflation vanished in May according to both the producersí and consumersí price indices.  The bad news is that the good news already is over. 


A drop in energy and food prices (mostly dairy and fruit prices) led to a substantial decline in the producersí price index in May.  After those items were stripped away, prices grew a scant 0.1 percent at the finished goods level. 


At earlier stages of processing, the inflation performance was even more favorable.  Intermediate goods experienced a 0.3 percent price decline without food and energy while crude materials.  A component of my inflation indicators, crude materials other than food and energy, fell 3.6 percent following two small monthly increases. 


The less volatile consumer prices were not that encouraging.  In the past year, core inflation (prices less food and energy) rose 2.2 percent.  They did the same in the past three months. 


Before cheering price stability several items need to be noted. 


Of course, the most important one is energy.  Prices will rise about as much in June as they fell in May assuming no further oil price gains for the remainder of this month.  Energy price gains do not directly impact the core prices I was discussing above.  However, all goods are shipped somewhere and many require processing that uses energy.  Therefore, those declining core prices at earlier stages of processing in May do not mean finished goods prices will be falling in June or beyond. 


Also, 32 percent of the consumer price index is the cost of shelter.  A sharp decline in average daily room rates for lodging accounted for no change in that index both in April and May.  I have been tracking lodging rents every week for several years and acknowledge that those rates dipped in the early spring.  In the latest week, room rates were back to their 5 percent gains from previous year rates that they had established earlier in the year. 


In short, look for lodging rents to rise in June, taking away that very favorable core inflation performance. 


On the other hand (I am an economist), the GM auto discounts are not reflected in the May pricing report.  They will hold down auto prices in June.  By then, the discounting of womenís apparel following the spring fling in fashions will be over.  Also, a larger than normal price reduction for computers may not be repeated. 


However, those last components of the price index always are fluctuating with little trend over time (except for the monthly percentage point drop in computer prices).  The 5 percent recent trend growth in medicine and its services is intact while the nearly 7 percent annual tuition increase is lumped in with the falling computer prices. 


I certainly could again wonder how consumers are only using 4.6 percent of their budgets for medical care services when medicine is now 14 percent of our economy.  (Yes, governments and employers pay the rest.  Furthermore, the consumerís co-pay adjustments are not considered as an increase in household medical costs, which dramatically distorts the purchasing power of households over time.)


So what should we take away from all these May inflation numbers?


First, they are favorable.  Even if most of the relief was at the gas pump, more jingle was left in the pocket to purchase something else.  Expect to see a solid rebound in retail sales in the next few months. 


Second, the favorable gains are fleeting.  Gasoline prices again are rising and may not dip again until after Labor Day.  If consumers reduce their conversion of home equity into consumer goods, they will not have enough jingle to preserve current strong spending growth through the remainder of this year. 

Third, some core measures are above the 2 percent price target that the Fed is rumored to desire for our economy.  This means their work is not yet done. 


Fourth, even with higher energy prices this year than last year, core inflation is not intensifying.  Thus, the Fed does not need to quicken its pace to get to its overnight interest rate destination.  Moreover, that destination may not be too far away.  (4 to 4.25 percent according to my reckoning.)


Fifth, if inflation is to be fundamentally lowered, we need to address specific sectors, such as medical services and education, to find out why price relief is so difficult there. 


Sixth, while the inflation indicators are our best estimators of overall price change, they need serious adjustments, especially in the medical and homeownership areas. 


In the meantime, letís enjoy the good inflation news for May.  It will not be followed by more good news in June. 

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