US prices are falling. The 0.7% decline in US consumer prices was the largest monthly drop since December 2008. Consumer prices in January fell 0.1% from a year ago. The last time the year-over-year CPI was negative was when the US economy was just beginning to recover from deep contraction associated with the end of the credit cycle and the financial crisis.
Does this mean that US is experiencing deflation? If so why is the Fed preparing the market for an eventual rate hike?
Recall what inflation and deflation means to policy makers. It refers to a change in the general level of prices. What the headline CPI is picking up is the out-sized drop in energy prices. The energy component of CPI fell almost 10% in January. The gasoline index plummeted almost 19%.
There is a reason why the Federal Reserve targets core inflation. Over the past half-century or so, headline inflation converges to core inflation--not the other way around. As households, of course, we pay for food and energy, but when setting policy, officials focus try to focus on the underlying price signal, not the noise.
The core rate was stable at 1.6%. This measure has also drifted lower since reaching 2.0% last May. In her testimony this week, Yellen reiterated the Fed's view that current low inflation readings generally a relative price adjustment (the fall in energy prices) rather than a general decline in prices. Moreover, this is a transitory phenomenon. Later this year and into early next year, the drop in oil prices will fall out of the year-over-year comparisons.
The role of hydrocarbons in US economy is extensive and the drop in oil prices has been so dramatic that it appears to have some leakage into the core rate. Yellen acknowledged this in her testimony, which is not the first time.
Yellen specifically indicated that it might be appropriate to raise rates when "the Committee is reasonably confident that inflation will move back over the medium term toward out 2% objective" (alongside continued improvement in the labor market). Yellen's comments suggest the FOMC is unlikely to change the characterization seen in the January FOMC statement: "Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2% over the medium term."
The core prices rose 0.2% in January. The consensus had expected a 0.1% increase. The December series revised to 0.1% from a flat report initially. Today's report should help boost Fed officials' confidence of their own baseline forecast for a medium term recovery price pressures.
To be sure, the Fed does target core CPI, but also the core PCE deflator. For various reasons, the core PCE deflator tends to run lower than the core CPI. In December, the core PCE deflator was 1.3% compared with the core CPI of 1.6%. The January PCE deflator reports next week. The Bloomberg consensus calls for a 0.1% increase on the month, but for the year-over-year rate to slip to 1.2%. This is where it was when the Fed began to taper its asset purchases.