The U.S. Consumer Price Index rose in February at its fastest rate since the recovery began almost four years ago, according to the latest report from the Bureau of Labor Statistics. The monthly increase in the all-items CPI for urban consumers was 0.7 percent, equivalent to an annual inflation rate of 8.73 percent. The report comes after a four-month period over which the CPI had remained essentially unchanged.
The increase in the inflation rate came mostly from a 9.1 percent jump in gasoline prices. Other energy prices also rose, but more moderately. Energy prices as a whole have a weight of 9.5 percent in the CPI.
The all-items CPI gives a good picture of monthly changes in the cost of living for urban consumers, but because food and energy prices are highly volatile, it is a poor indicator of underlying inflation trends. One popular measure of the underlying trend is the core CPI, which is simply the all-items CPI with the food and energy components removed.
As the following chart shows, the core inflation rate of 2.43 for February was down slightly from January and very close to its average of just over 2 percent for the previous two years. The Fed considers inflation of 2 percent per year to be consistent with its mandate to maintain price stability. In contrast to the subdued behavior of the core index, the all-items CPI is subject to much greater month-to-month variability. For example, in June 2009, all-items CPI inflation spiked to an annual rate of over 10 percent, before falling back to a negative rate in the following month.
The sharp uptick in inflation will make good headlines, but investors appear unconcerned. One of the best gauges of inflation expectations is an index supplied by the Federal Reserve Bank of Cleveland. It uses information from Treasury Inflation Protected Securities (OTC:TIPS) to calculate both an expected inflation rate and a risk premium, which together account for the spread between TIPS and ordinary treasuries of similar maturity. The next chart shows that both 5-year and 10-year inflation expectations are stable and well below the Fed's 2 percent target.
Using a somewhat different methodology, researchers at the Atlanta Fed use TIPS data to calculate the expected probability of deflation. The next chart shows that as recently as last August, TIPS investors were foreseeing a 15 percent probability that the price level in 2017 would be lower than the price level in 2012. Since then, the probability of deflation implied by TIPS prices has fallen to zero.
Taken together, extremely low expected inflation and a zero probability of deflation suggest that bond market participants have confidence in the Fed's willingness and ability to hold the rate of inflation close to or a little below its announced target. Of course, these data will not convince everyone. Some people will undoubtedly interpret the February spike in CPI inflation as an indication that the long period of price stability is at an end for the U.S. economy. If the inflation Cassandras are right this time, the few who believe them will undoubtedly make a killing by betting against the balance of market expectations.
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