ECONOMIC OUTLOOKA tenth on the core CPI could be...

ECONOMIC OUTLOOK
A tenth on the core CPI could be decisive
Inflation expected to moderate in May, but will it be enough for the Fed?
E-mail | Print | | Disable live quotes By Rex Nutting, MarketWatch
Last Update: 5:56 PM ET Jun 13, 2006


WASHINGTON (MarketWatch) -- When it comes to the market reaction to the May consumer price index report, a tenth of a percentage point could make all the difference.
The Labor Department will report on consumer inflation on Wednesday at 8:30 a.m. It's the most anticipated economic event of the week, because it could be the deciding factor in whether the Federal Reserve raises interest rates again in late June or holds rates steady.
Economists expect the CPI to rise 0.4% in May after a 0.6% gain in April. That would push the year-over-year inflation rate up to 4% from 3.6%. See Economic Calendar.
But the more important number for the markets is the core CPI, which excludes food and energy costs. The Fed watches core prices for underlying inflationary trends.
Economists expect the core CPI to rise 0.2% after rising 0.3% in both March and April. A 0.2% gain would push the year-over-year increase to 2.4%, above the Fed's so-called comfort zone.
"This week's core CPI number is hugely important," said Ian Shepherdson, chief U.S. economist for High Frequency Economics. "Another 0.3% rise would seal a June hike, a 0.2% wouldn't change much, and 0.1% would re-open the whole question of how much pressure is in the system."
Ahead of the CPI figures, most analysts expect the Fed will raise overnight lending rates again on June 29 out of concern that inflationary pressures are building to unacceptable levels. Higher rates can cool the economy, bringing supply and demand back into balance and curbing the ability of firms to raise prices.
But higher rates could cool the economy too much. Fed officials are wary of raising rates too high, knowing that inflation typically peaks long after the economy starts to stall.
In May, energy prices probably rose about 2%, said Nigel Gault, an economist for Global Insight. Gasoline prices -- after seasonal adjustments -- probably increased about 4.5%, about half April's gain.
Question marks
As for the core CPI, there are two main question marks, both revolving around statistical issues, not fundamental ones: Apparel prices and homeownership prices.
Apparel prices have been falling for most of the past eight years and are down 11% from 1998 levels. But apparel prices spiked higher in March and April, rising at the fastest rate since 1990. Was that a statistical fluke caused by faulty seasonal adjustments, or a new trend toward higher prices?
Most economists are counting on some kind of payback in apparel prices in May, which would hold the core CPI down.
"Our 0.2% forecast on the core CPI hinges on apparel prices," although apparel accounts for just 5% of the CPI, said Joseph LaVorgna, an economist for Deutsche Bank.
"If apparel prices fall more than expected we may round down to 0.1% on core," LaVorgna said. "Conversely, if they stay stubbornly high, we could be looking at 0.3%, which would obviously be troubling to financial markets. We think that the risks to our core CPI forecast are symmetrical -- we can envision 0.1% or 0.3%."
Owners' equivalent rent
The other issue comes from owners' equivalent rent, which is the method the Labor Department uses to measure the price of owning a home.
In both March and April, owners' equivalent rent rose 0.4% for the second and third time since late 2001. With equivalent rent accounting for nearly one-fourth of the CPI, those 0.4% gains were a major factor in nudging the core CPI up 0.3% in March and April.
But some economists said the acceleration in the core CPI didn't show more inflation, but rather was the perverse result of a slowing housing market.
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