by Calculated Risk on 12/19/2007 01:44:00 PM

From Richmond Fed President Jeffrey Lacker: Economic Outlook

Since August ... the inflation picture has deteriorated. In September and October, the overall PCE price index rose at a 3.3 percent annual rate, and the core index rose at a 2.6 percent rate. Judging by the closely related consumer price index, the numbers for November will be even worse. Now these numbers do display transitory swings, so I wouldn't extrapolate them forward indefinitely. Still, I have to say that I am uncomfortable with the inflation picture, and disappointed that the improvement we saw earlier this year was not more lasting.

I am also troubled by the lengthy divergence we've seen between overall and core inflation. Some of you may recall that core inflation was devised in the 1970s to filter out some of the more volatile consumer prices to get a better read on inflation trends. For several decades, core inflation seemed to work well due to the fact that food and energy prices had no clear trend relative to the overall price level. In the last few years, though, overall inflation has been persistently above core inflation, and few observers expect oil prices to go back below $20 per barrel. Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation. Going forward, markets expect oil prices to back off slightly from their current level, and I hope they are right. If energy prices fail to decline, monetary policy decisions will be that much more difficult in 2008.

Lacker isn't currently a voting member of the FOMC, and last year he voted against holding the Fed Funds rate steady several times:

Voting against was Jeffrey M. Lacker, who preferred an increase of 25 basis points in the federal funds rate target at this meeting.

So we need to keep Lacker's comments in perspective; he is more hawkish on inflation than most of the FOMC members.

For fun, here is how you calculate the two month PCE and core PCE inflation rates that Lacker mentioned. Using monthly data from Table 2.3.4U. (link shows quarterly data), we see that the PCE price index (line 1) in August was 117.711 and 118.356 in October. For the annualized rate from a two month period, first divide 118.356/117.711 = 1.00548. Take that to the 6th power (2 months = 1/6 of a year) and subtract 1. That gives 3.33% (Lacker rounded to 3.3%).

For the Core PCE inflation rate (line 23), the August number was 114.591, October was 115.074. So the annualized rate for two months was (115.074/114.591)^6 - 1 = 2.56% (Lacker rounded to 2.6%).

Finally, this graph shows the "lengthy divergence" between the PCE and core PCE inflation rates.

Click on graph for larger image.

Note that this graph is of the year-over-year change, and Lacker was talking about the two month annualized rate of change. The annualized rate over the last two months is higher, so the picture has definitely deteriorated.

The "lengthy divergence" (blue above red) has been mostly due to the rapid increase in oil prices.