Consumer Price Index Dichotomy Between Overall and Core Prices Persists. CPI-U: All Items. % Change - Year to Year NSA, =100

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1 Asha G. Bangalore Consumer Price Index Dichotomy Between Overall and Core Prices Persists May 13, 2 The Consumer Price Index (CPI) rose.% in April after a.% increase in March. The CPI has posted gains between.% and.% for five consecutive months, putting the five month annualized change in the CPI at.8%. Under other circumstances the Fed would view the recent readings of overall inflation as severely inflationary and engage in suitable monetary policy actions to prevent further increases in prices. The present situation is different. The energy price index has risen for ten straight months, with the increase in April at 3.1%. Higher gasoline prices (+3.6%) accounted for half the increase of the CPI. Food prices rose.% in April, with the yearto-date increase at 7.%. Chart 1 CPI-U: All Items % Change - Year to Year NSA, = CPI-U: All Items 3-month %Change-ann SA, = The core CPI increased.2% in April, which translates into a 1.3% gain from a year ago. The year-to-year change in the core CPI is not worrisome, but the 3-month annualized increase at 2.1% puts the core CPI at the top of the Fed s watch list. Further gains of the core CPI would imply more than concern at the FOMC. -1

2 Chart CPI-U: All Items Less Food and Energy % Change - Year to Year NSA, = CPI-U: All Items Less Food and Energy 3-month %Change-ann SA, = It is noteworthy, that prices of new and used cars have risen sharply in the past three months, while sustained increases are unlikely as these gains appear to be sporadic. Shelter costs, the largest component of the core CPI, show a small increase but it is largely contained. Medical care costs continue to trend up (see Chart 3 for these price trends). These readings suggest that the core CPI is likely to show muted gains in the months ahead unless shelter costs show an accelerating trend

3 Chart 3 Shelter Costs 3-month annualized change New and Used Car Prices 3-month annualized change Medical Care Price Index 3-month annualized change The Fed is not likely to tighten monetary policy until there are sustained and significant increases in employment. Large increases of the core CPI and an unexpected hike in the policy have a remote chance of occurring in the months ahead. The elevated level of the unemployment rate and soft demand conditions are supportive of this view. -8 3

4 Consumer Price Index April 2 % change % change annualized % change % change prior month year-to-date 3 mo. ago 6 mo. ago Apr- yoy Dec- yoy CPI - ALL ITEMS CORE - ALL ITEMS LESS FOOD & ENERGY (77.18)* CPI ALL ITEMS LESS ENERGY (9.9) FOOD (13.7) ENERGY (9.8) SHELTER (32.) COMMODITIES (.1) COMMODITIES LESS FOOD & ENERGY (2.9) SERVICES (9.9) SERVICES LESS ENERGY SERVICES (6.3) FRB CLEVELAND TRIMMED-MEAN CPI * - Figures in parentheses denote the relative importance of each category in the CPI. U.S. Debt Ceiling: Facts and Thoughts In the April, 2 letter to John Boehner, Speaker of the House of Representatives, Treasury Secretary Geithner indicated that if the debt limit ($1.29 trillion) is not raised by May 16, 2, the Treasury would undertake extraordinary measures. The letter listed the extraordinary measures as (1) suspending sales of State and Local Government Series (SLGS) Treasury securities; (2) determining that a debt issuance suspension period exists, which would permit the redemption of existing, and the suspension of new, investments of the Civil Service Retirement and Disability Fund (CSRDF); (3) suspending reinvestment of the Government Securities Investment Fund (G Fund); and () suspending reinvestment of the Exchange Stabilization Fund (ESF) In further communication on May 2, 2, Secretary Geithner indicated that these measures would be put in place as of May 16 if Congress has failed to raise the statutory debt limit. He also noted that due to stronger than expected tax receipts and if the extraordinary measures are enacted to buy time, the Treasury could operate within the current statutory borrowing limit until August 2, 2. These are facts of the case. Secretary Geithner s description of the chain events if appropriate action is not taken is as follows: Delaying action risks a loss of confidence and accompanying negative economic effects As I have written previously, default by the United States on its obligations would have a catastrophic economic impact that would be felt by every American. A broad range of government payments would have to be stopped, limited or delayed, including military salaries, Social Security and Medicare payments, interest on debt, unemployment benefits and tax refunds. A default on the Nation s legal obligations would lead to sharply higher interest rates and borrowing costs, declining home values and reduced retirement savings for Americans. Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.

5 We strongly believe a political compromise will be reached and that default will be an imaginary case study. Nevertheless, consider a hypothetical case of Congress failing to raise the debt ceiling. The financial world would be treading in unknown waters essentially. At the present time, financial markets are not spooked, there is relative calm. As the August deadline approaches, uncertainty would translate into significant financial market volatility. The Treasury Department would have to operate on a cash flow basis and may have to prioritize its payments. As noted by Secretary Geithner, several government payments would have to be stopped, limited, or delayed. The U.S. dollar would take suffer a severe setback. More importantly, the risk-free status of Treasury securities would be lost and financial market valuations would be affected as a benchmark would no longer be available until another is invented. A default would lead to higher interest rates and further exacerbate the situation. These are the immediate consequences. More importantly, the medium-term impact should be severe as higher interest costs would hold back the pace of economic growth of an already fragile economy. In the long run, the sterling status of Treasury securities would be tarnished and raise future funding costs as foreign appetite for U.S. debt would be reduced. This in turn would render the challenge of debt management a few notches higher from the present situation.