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Inflation pressures are building in the production pipeline

These two charts compare headline and core inflation at the producer and consumer level. While it's true that the recent inflation statistics have been relatively mild (e.g., the recent two-month decline of 0.23% in the CPI) this year, if there is one thing these charts show it is that inflation at the producer level is rising relative to inflation at the consumer level. Note how year over year PPI inflation was consistently below that of the CPI throughout the 1990s and into the early 2000s (this is quite clear on a core inflation basis). Since 2003 the PPI has tended to equal or exceed the CPI on both a core and headline basis.

One reason for the difference between producer and consumer inflation is that commodity prices have a more direct and immediate impact on producer prices than they do on consumer prices. Commodity prices were very weak in the 1990s and through 2001, but they have been very strong since 2002. Same goes for the dollar, which was generally strong from 1990 through 2002, and generally weak ever since, and that ties in directly with the stance of monetary policy, which was generally tight throughout he 1990s and early 2000s, but has been accommodative ever since. A strong dollar helps keep commodity prices low, and it also tends to keep import prices low. Monetary policy, in short, is currently acting to boost inflation in the early stages of the production pipeline, and easy money will allow that inflation to eventually pass through the pipeline to reach the consumer. Call the PPI an early warning indicator of what is going to be happening to the CPI in a year or two.

Another reason for the difference is that consumer inflation is being kept low due to the very weak housing market, which in turn has put downward pressure on homeowners' equivalent rent, which represents about one-third of the CPI and which has declined (for the first time ever) by 0.3% since last August.

I think it's appropriate to focus on the monetary fundamentals here, and thus to pay more attention to the producer price index than to the CPI. That leaves me with the observation that inflation is currently running between 2-4%, as I noted in yesterday's post, not the 0-2% that is being registered in the CPI.

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