CPI Release

At 8:30 the CPI numbers were released. While the overall number was a bit of a surprise (+1.2%), the highest rate in 25 years, the core inflation rate (which excludes both food and energy) was very tame (+0.1%). A good reference for market reaction is at MarketWatch.com. An article on the report itself is also at that site. The initial reaction by the fixed income market was very favorable -- the 10-year bond rate fell by 5 basis points.

As I watched CNBC, I was amused by the reaction to the CPI number by both Mark Haines and Becky Quick -- both refused to believe the number. They cited how high the levels of prices have become, and cited the obvious examples in their lives. Steve Liesman, the economics person (but not economist) correctly pointed out that inflation reflects the rate of change in prices, not their level. This is a critical and often midunderstood point. So, if prices rise to a "high" level and remain there, the inflation rate from that point would be 0%!

The critical issue here is called "pass-through." While the core inflation rate nets out the direct changes in food and energy prices, the overall effects of energy and food prices can and do spill over into core inflation. Note the recent price hikes by shipping companies (UPS and FedEx). The Federal Reserve pays the most attention to pass-through. They are betting that there is enough underlying strength in the economy to allow them to fight the inflationary effects in motion (pass-through) without causing a recession. I have some serious reservations about their strategy. Read about today's release on Industrial Production -- hardly cause for celebration. The Consumer Sentiment Index also showed weakness.

For the Fed, they still see a problem because they want to contain core inflation at below 2% annually. Even with the favorable report this morning, core inflation is running around 2.1%. Remember from our multiplier discussion yesterday, that there are lags in monetary policy. So, as spending is hurt by monetary tightening, it takes time, about 2-3 quarters, for the multipliers to work. This means that for the Fed to head off future inflation, it must act ahead of time. This fact is what confuses so many people.