Inflation Variables Better

The consumer price index for May, combined with recent CPI data, moderating wages and employment cost, and, remarkably, a strengthening of the dollar, provides a convincing case for optimists to claim that a moderation in core inflation is underway. The nagging problem, of course, is the continued buoyancy of commodity prices and its impact on inflation expectations.

Which will win out? Much depends upon the resolve of the world's central banks, the words and deeds of both the world's finance ministers with respect to the U.S. dollar, and on OPEC's willingness to act decisively when it meets in Jeddah, Saudi Arabia June 22 to stem the surge in the price of crude oil.

Over the past four months, core prices have increased a cumulative five-tenths of a percentage point -- a 1.5% annual rate, which is well below the year-over-year gain of 2.3%. This trend offers hope of a trend change, although it is important to keep in mind that there is a tendency for the CPI to be more moderate in the first half of the year than the second half.

Nevertheless, supporting the moderating is the recent trend in wages, which have increased at a 3.5% pace, down from a peak of 4.3%. In addition, employment costs increased just 0.8% in the first quarter, the least in two years. These data are important given that labor accounts for about 70% of the inflation story.

A new force that is both too young and too small to have influenced prices but which could help in future months is the rebound in the dollar. The Federal Reserve's trade-weighted dollar index has reached a four-month high, which will eventually help to steady import prices.

As convincing as these data are with respect to the inflation outlook, the Federal Reserve is placing greater weight than normal on inflation expectations, not on Wall Street but on Main Street, where inflation expectations are significantly higher. The key variable here is of course oil, the galvanizing force that could sway Main Street and hence, the Fed.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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