Modest Inflation, Modest Economic Growth Ahead

The latest official measurement of prices shows no sign of imminent deflation and not much inflation. That leaves monetary policymakers searching for clues about what lies ahead and also with the flexibility to do nothing for the time being.

We expect more of the same into next year. The Consumer Price Index overall rose 0.3% in August, fueled largely by a statistical increase in gasoline prices. Actual pump prices didn’t change much from July to August, but they usually decline. In CPI calculations, that translates into an increase of nearly 4% for gasoline costs. Aside from that, prices of fruits and vegetables rose, as did costs of medical care, airline fares and both new and used cars. Apparel declined, as did the cost of recreation.

At the end of the day, the report gives Federal Reserve Chairman Ben Bernanke more time to wait and see before making a move. He’ll seek more stimulus -- probably in the form of Fed purchases of Treasuries or ending the practice of paying interest on reserves held by banks -- only if the economy weakens. At the same time, he’s not inclined to agree with some members of the policy-setting Federal Open Market Committee who fear that the long period of rock-bottom interest rates is paving the way for prices to surge when the economy kicks into high gear. They want interest rates raised now, despite the sluggish economy.

The fact is, there are plenty of signs that show an economy that is growing, but at a modest pace. The monthly tally of the length of the average workweek, for example, has regained half of the ground it lost during the downturn, although it’s still short of its prerecession norm of 34.6 hours. Keeping workers on the job longer doesn’t deliver the same kind of boost to the economy that new hiring does. But the trend is up, and working more hours does put more money in employees’ pockets.

In another hopeful signal, retail sales posted a solid gain in August and are on track to increase about 4% this year. Sales in the all-important holiday season should be up about 3% in 2010 -- no boom, but much better than the 1% gain in 2009. Broader consumer spending, which includes services as well as goods, is likely to increase 2%, a decent, if unspectacular, gain for the 70% of gross domestic output accounted for by consumer spending.

Looking ahead at inflation, we expect the 2010 CPI increase to wind up just under 1% by December, picking up the pace to a still low 1.5% in 2011. For the past 12 months, the CPI is up 1.1%. Core inflation, which excludes both the volatile energy and food sectors and is therefore a better gauge of underlying trends, will also rise modestly. Flat in August, the core CPI rose 0.9% over the past 12 months and will likely remain subdued. It’s heavily influenced by rents, and a slack economy is keeping the lid on.

But deflation at the core level remains unlikely. The economy is gradually reducing slack in employment and capacity use, leading us to think that modest inflation is a more likely scenario through 2011.