Monday, 22 March 2010

Will US inflation stay low?

Inflation in the United States has remained low even as the economy has begun to recover.

The Labor Department reported on Friday that US consumer prices were unchanged in February. This brought the year-on-year change in the consumer price index down to 2.1 percent from 2.6 percent in January.

Consumer prices excluding food and energy rose 0.1 percent in February after having fallen 0.1 percent the previous month. Compared to February last year, consumer prices less food and energy were up 1.3 percent, less than the 1.6 percent increase in January.

The inflation report on Friday followed the decision by the Federal Open Market Committee on 16 March to keep the federal funds rate unchanged at between zero to 0.25 percent. In its statement issued after the monetary policy meeting, the FOMC cited, among other things, subdued inflation trends as likely to warrant "exceptionally low levels of the federal funds rate for an extended period".

The FOMC statement also mentioned low rates of resource utilisation as a factor in keeping the federal funds rate low. Indeed, the unemployment rate was at 9.7 percent in February and a report by the Federal Reserve last week showed that industry capacity utilisation rate was only 72.7 percent that month, significantly below the 80.6 percent average for the period from 1972 to 2009.

Nevertheless, the trends in resource utilisation do indicate that this period of disinflation may not necessarily last. The recovery in the US economy since the middle of last year is already making a dent in resource slack, with the unemployment rate having come off its peak of 10.1 percent in October last year and the capacity utilisation rate up from its trough of 68.3 percent in June last year.

If the economic recovery is sustained and these improving trends in resource utilisation hold, then inflation is likely to pick up. The accompanying chart shows that historically, when both the unemployment rate is on a sustained downtrend and the industry capacity utilisation rate is on a sustained uptrend, inflation more often than not accelerates.

The Economic Cycle Research Institute also sees rising inflationary pressures. Its future inflation gauge rose 10 consecutive months before falling in February to 101.4 from 102.1 in January. Despite the decline in February, ECRI managing director Lakshman Achuthan said on Friday that the inflation gauge "remains in a cyclical uptrend, with underlying inflation pressures continuing to trend upward".

Also, while the Fed talks about subdued inflation trends and low rates of resource utilisation, purchasing managers in industry are mostly indicating higher prices. The Institute for Supply Managers' survey of purchasing managers showed that the prices index for February was 67.0 in manufacturing and 60.4 for non-manufacturing. Both are thus substantially above the 50 reading that indicate generally stable prices and are, in fact, around the levels commonly seen during 2007 when inflation was so much a concern.

So despite the Fed's dovish stance, there are signs of incipient inflationary pressures already building up. To what extent these pressures translate into actual acceleration in inflation will depend on how sustainable and strong the on-going economic recovery turns out to be.

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