US inflation falls but hold the celebrations

Consumer price inflation in the United States edged down further in April. This is good news for the economy and for markets. However, it is still too soon to declare that inflation has been beaten.

Yesterday, the Labor Department reported that the consumer price index rose 0.4 percent in April, down from the 0.6-percent rise in March. Food and energy prices were responsible for much of the increase, rising 0.4 percent and 2.4 percent respectively. The core index that excludes food and energy prices rose 0.2 percent, up from 0.1 percent in March.

On a year-on-year basis, the headline CPI rose 2.6 percent in April, down from 2.8 percent in March, while the core CPI rose 2.3 percent, down from 2.5 percent in March.

Economists generally welcomed the news, saying that it is a sign that inflation is abating with the slowing economy, much as the Federal Reserve expects. In fact, if the core CPI rose 2.3 percent year-on-year in April, the core personal consumption expenditures price index, the indicator that the Federal Reserve focuses on as a measure of inflation, could have risen at about 2 percent or even less. In other words, inflation could have fallen within the Federal Reserve's comfort zone in April.

Nevertheless, we should probably hold the celebrations for the time being. While the inflation data yesterday were benign, further moderation could be limited, especially if the economy turns around as most economists expect.

In fact, the latest survey of professional forecasters by the Philadelphia Federal Reserve Bank shows that the forecasters expect core CPI inflation to average 2.3 percent in each of the next three years while core PCE inflation will average 2.1 percent over the same period. Real gross domestic product will recover from the first quarter low to grow 2.1 percent for 2007 as a whole with a further acceleration to 2.9 percent for 2008.

Indeed, the latest data from the Institute for Supply Management released earlier this month, apart from showing that the indices on economic activity have been rising, also show that the price indices are on a rising trend again. The headline CPI generally moves together with the ISM price indices. The core CPI, which tends to lag headline CPI, could yet accelerate in coming months.


However, as a measure of underlying inflation, the Labor Department's CPI less food and energy does not have a monopoly. In fact, in my opinion, the Federal Reserve Bank of Cleveland's 16% trimmed-mean CPI is a better measure. It tracks the trend in headline CPI slightly more closely than the CPI less food and energy without showing significantly more volatility. It also does not significantly lag the headline CPI so it identifies turning points in inflation better.

The trimmed-mean CPI rose 0.2 percent in April, down from 0.3 percent in the previous three months. However, on a year-on-year basis, the trimmed-mean CPI rose 2.8 percent, practically unchanged from the previous two months.


So it is too soon to conclude that inflation has been tamed. Certainly, the Federal Reserve itself continues to drum the same message into our ears at the end of every Federal Open Market Committee meeting, including the one last week: the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.

Indeed, markets may face a test in coming months. There is a real possibility that investors see the ongoing decline in core inflation and become complacent about inflation and interest rates. If and when inflation turns back up, markets could be in for a bit of a shock.