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The inflation rate is easing, but interest rates won't follow anytime soon. Officials at the Federal Reserve are surely pleased with the October inflation report showing another big, energy-fueled decline in the Consumer Price Index (CPI) and a modest 0.1% rise in the closely tracked core CPI, which excludes food and energy costs.
However, Fed officials don't think the economy is out of the inflation woods yet. We expect the central bank to keep rates steady throughout most of 2007 to help fend off growing wage pressures, which have the potential to stoke prices over the course of the coming year. Economic growth is also likely to remain strong enough to justify steady rates for a while, despite the drag from the slowdown in the housing market. Gross domestic product is on course to gain about 2.5% next year.
In their last policy meeting in late October, Fed officials noted that core inflation "remained undesirably high." They also voiced concern about a possible upward drift in the future inflation expectations of businesses and consumers, which could further fan the flames of price growth, "if core inflation remained elevated for a protracted period." This is Fedspeak for no rate cuts on the horizon.
The October numbers put the core CPI up 2.7% over the past 12 months, down from 2.9% in September, but still well above the Fed's unofficial limit of about 2%. While the core rate is heading in the right direction, it still has a ways to go before monetary policymakers might feel comfortable about lowering interest rates.
The Fed is likely to keep the benchmark federal funds rate at its current 5.25%, while banks' prime rates stay at 8.25%. The Fed's cautious approach will keep bond investors in a holding pattern. The yield on the 10-year Treasury note will bob between 4.7% and 5.25% in 2007. The current yield is around 4.6%.
Energy prices, while not directly included in the core CPI, are helping to reduce the core's growth rate indirectly through their impact on prices of transportation and utilities. But other elements in the inflation calculation continue to gain—notably rents, which account for about a third of the index, and costs for medical care and education. As a result, we see the core rate slowing only gradually, ending this year at 2.5% and easing to 2% toward the end of 2007.
The headline CPI was up only 1.3% in the year through October, mainly reflecting two straight months of steep declines in energy prices, which compare with huge energy price hikes in September and October of last year. This effect will be partly reversed in November and December, leaving the CPI up about 3% for the year. Next year, inflation will slow to about 2.5%.
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