Today’s consumer price inflation report for May 2014 showed a greater-than-expected increase in the year-over-year figure to 2.1%, the largest annual gain since October 2012. (Similarly, the “core” measure, which excludes volatile food and energy prices, rose to 2.0%, the greatest increase since early 2013.)
Charts 1 and 2 show the upward trajectory in inflation is not a one-month phenomenon; similarly, looking at the components of consumer inflation highlight that the advance has been broad-based and spread across both goods and services.
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Chart 1. Consumer Price Index and Personal Consumption Expenditures Index, YoY Percentage Changes
Chart 2. Core Consumer Price Index (Excluding Food and Energy), 3-Month Annualized Percentage Change
It is likely that the uptick in inflation will be well-received by the Fed. While progress has been made in reducing the unemployment rate, a sign that the labor market is on the path to full employment—one of the FOMC’s two mandates—the shortfall in inflation has been worrisome; the minutes to the last FOMC meeting, held in April, noted that, “inflation was running below the Committee's longer-run objective and was seen as posing possible risks to economic performance…in light of their concerns about the possible persistence of low inflation, members agreed that inflation developments should be monitored carefully for evidence that inflation was moving back toward the Committee's longer-run objective.”
Table 1. Consumer Price Index Components, 3-Month Annualized and 12-Month Percentage Changes
While an excess of inflation would unwelcome, higher inflation implies lower real rates. Since we’re already at a zero nominal lower-bound for the Fed Funds rate target, the higher the inflation rate, the lower the real Fed Funds rate becomes, which allows for even more accommodative policy. At some point, the Fed will begin to reduce the liquidity it has provided; already, it has been scaling back its assets purchases. (Tomorrow’s policy directive likely will reduce asset purchases further, taking total monthly purchases to $45 billion to $35 billion.) While the FOMC has also discussed reverse repo operations (temporary sales of securities whereby cash is removed from the system), the timing of such measures is still a 2015 event at earliest.