In June, the Consumer Price Index rose 1.1%. Over the past 12 months, headline inflation has now reached 5.0%. That is the highest annual reading since February 1991 when inflation came to 5.3%. Core inflation (excluding food and energy prices) ticked up to an annual rate of 2.4% as the monthly increase came to 0.3%, which exceeded the consensus economic forecast of 0.2%.
In the wake of the Fed’s substantial easing of monetary policy beginning last September under which the federal funds rate was slashed by 325 basis points from 5.25% to 2.00%, inflation has been increasing. Over the course of 2008, particularly following the 125 basis point reduction in interest rates over an 8-day period in January, inflation has been accelerating.
Annualized Inflation Rate for the 6-Month Period Ended:
January 2008: 2.7%
February 2008: 3.7%
March 2008: 4.9%
April 2008: 5.7%
May 2008: 6.2%
June 2008: 8.5%
If one examines the annual inflation rate over the past 5 years (June 2003-June 2008), one finds that the inflation rate was generally rising during periods of negative real interest rates and falling during positive real interest rates (periods divided by light blue vertical lines on the graph). The real federal funds rate is now -3.0%. The periods marked by red vertical lines indicate periods of rate hikes, rate reductions and rate pauses.
Considering a likely continuation of the Fed’s overly accommodative (negative real rates) monetary policy, there is likely a growing danger that an adverse inflation-inflation expectations feedback loop could develop.
It should be noted that the Fed continues to possess the capacity to provide liquidity where it is needed in a monetarily neutral fashion. Therefore, were the Fed to undertake a modest 25 to 50 bp interest rate hike at its next meeting (August 5), it could do so without depriving the financial sector of needed liquidity.
Right now, given the economic uncertainty, I would favor a 25 bp rise in August and a more gradual path of rate hikes through the rest of the year with the federal funds rate having been increased by 50 to 100 bp by year-end. However, odds presently favor no rate hikes whatsoever, even as inflation quickens.