So far the Doves have it. The Doves are winning their battle against the Hawks as inflation concerns stay muted.
The Doves are monetary policymakers who believe interest rates must be kept low to encourage consumer spending and economic growth. Their opponents are called Hawks, policymakers who say monetary policy must be tightened, meaning higher interest rates. Hawks concede that economic growth is slow but see inflation threat rising from loose monetary policy.
Federal Reserve Bank of Cleveland President Sandra Pianalto appears to be in the Dove camp. She said this week that inflation will “only gradually drift up from its currently low level.” Thomas Hoenig, Kansas City Federal Reserve Bank president, is a Hawk. Hoenig has repeatedly objected to the Fed’s official statements that interest rates will be kept low for “an extended period”.
Doves like Pianalto have a commanding lead in the debate using current aggregate data on overall prices, but the financial markets have not changed their expectations.
This week the U.S. Department of Labor’s Bureau of Labor Statistics reported that on a seasonally adjusted basis the Consumer Price Index for All Urban Consumers declined 0.1 percent in April. The overall decline included a 1.4 percent decline in energy component. Other areas of decline included apparel and household furnishings.
Policymakers in the dove camp have pointed to these and other numbers f or support of continued low interest rates.
The financial markets “vote” every day about the winner in this debate. The key measure of inflation expectations in the financial market is called the yield spread. This spread is the difference between the interest rate currently earned on two-year and 10-year U.S. Treasury notes.
The yield spread this week stands at 2.6 percent — the difference between 3.38 percent for 10-year notes and 0.76 percent for two-year notes. This same 2.6 percent spread was in place last year at this time when 10-year notes were at 3.45 percent and 2-year notes at 0.839 percent. Before the financial crisis began in the fall of 2008, the spread was only 1.5 percent.
Despite one good month of news, the market has not changed its forecast for inflation. It is likely investors are looking past the headline inflation data and see strong evidence of higher prices in the details.
The CPI is a good but imperfect measure of inflation. The Bureau of Labor Statistics publishes the CPI for “All Urban Consumers.” It is designed to cover approximately 87 percent of the total population.
The index covers the prices of food, clothing, housing, fuels and other transportation costs, medical services, and other goods and services that “people buy for day-to-day living.” The Bureau collects prices in 87 urban areas across the country from approximately 4,000 households and 25,000 retail establishments.
To calculate the index, price changes for each category are averaged together by weights that are meant to represent their importance in the spending of an “urban consumer.” The current weights are 15 percent for food and beverages, 42 percent for shelter or housing, 4 percent for apparel, 17 percent for transportation, 7 percent for medical, 6 percent for recreation, 6 percent for education and communication, and 3 percent for other goods and services. These are the relative proportions of a monthly budget that the bureau has determined a typical consumer spends.
The headline inflation rate may be declining, but there is bad news on prices in many of these categories you probably noticed. Over the past 12 months, the sub-index for gasoline expenditures has increased 38.3 percent and the sub-index for all energy costs, which include natural gas, has risen 18.5 percent.
The bureau’s data for Western cities also shows high inflation. In western U.S. cities the same size as Boise, the index shows energy prices have risen 21.3 percent. Other prices in cities like ours are also rising rapidly. Overall transportation costs are up 12.8, percent and medical care services are up 3.6 percent over the last year.
The relative high weight the bureau places on housing costs in the CPI index and the vast variation in costs across different regions is masking real inflation problems. The financial markets have correctly maintained a forecast of higher expected inflation.
The Doves may have won the battle. Monthly, overall inflation remains low. But the Hawks should not surrender. The inflation war is far from over.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.