USA Outlook Update (Nov. 19, 2006): Inflation update

Inflation aspects based on CPI and CPI-core indices have been discussed in Comment 30 of May 29, 2006. The data covered in that comment only extends to CPI report of April, 2006. Since then six more monthly CPI reports have been issued. Especially both September and October CPI indices contracted substantially due to the sharp drop of the price of crude oil. CPI-core that is the Consumer Price index less food and energy also rose only by a small amount in October. Thus there is a prevailing mood in financial circles that inflation worry is the thing of the past. We want to analyze the situation of inflation here and to see whether or not such a rosy scenario is warranted.

In Comment 30 we have argued that CPI-core index is a lagging indicator and is pulled up or down by CPI index. The graph that led us to this conclusion is reproduced at the right. The bottom portion of the graph shows year-to-year percentage changes of CPI index in blue dots and CPI-core index in red dots. It should be clear from the graph that CPI-core index lags CPI-index by anywhere from 6 months to two years. Recent data does not change this general picture. In the case of CPI year-to-year changes, May data point rose from April data point (the rightmost blue point in the graph), and June data point rose further up to the value of 4.3%. Starting from July, CPI data points fell steadily and the last available data point of October had dropped to the value of 1.2%. CPI-core rose from April data point (the rightmost red dot) and reached the value of 2.9% in September. CPI-core year-to-year change pulled back to 2.8% in October. Considering the observation that CPI-core lags substantially behind CPI, the peak of CPI, from September of 2005 to June of 2006 will be felt by CPI-core until the middle of 2007, and CPI-core will only drop in the latter half of 2007. Thus we regard the minor drop of year-to-year percentage change of CPI-core in October just a normal statistical fluctuation.

We do not emphasize CPI-core since it is clearly a lagging indicator and is highly predictable from the behavior of CPI. The movement of CPI has been and will be dominated by the price of oil in foreseeable future. As oil price rose sharply in 2005 and in the first half of 2006, worldwide consumption, including that of USA, had fallen. The supply of oil started to outpace the demand. When speculators noticed belatedly the oversupply of oil, they took the price of oil down sharply. However, as oil price drops, the demand of oil in US is picking up again and so is the oil import of China. Sooner or later the demand of oil will catch up with the supply. When speculators notice the situation, again belatedly, they will push up oil price anew. This will panic oil users, they will start to overstock oil, market of oil will tighten, and speculators will bid up the price of oil further. This vicious cycle will create another round of skyrocketing oil price and substantially higher CPI. Therefore, we believe that the overly rosy scenario held by many market participants and observers about inflation is not warranted.

Contrary to the common view expressed on financial media, we do not consider the recent economic slowdown as the result of FED tightening or the sharp rise of oil price, but due to the general stagnation of the growth of US trade deficit. The stagnation of US trade deficit is due to the drop of US Dollar against the currencies of its major trading partners back at the stretch from 2002 to 2004 as depicted in article 9. The future course of US economy and the global condition of 2007 and beyond will not be discussed here. Interested readers are advised to stay tuned for a later Comment in the "Comments" section about the subject.