The Top-Line and the Core CPI: A Tale of Two Inflations

by: James Picerno

Thank goodness for core! For those intent on staying positive on the future path of inflation, focusing like a laser beam on the so-called core rate of the consumer price index is essential to one's mental health.

Friday morning's report on the CPI offers a potent example. On the surface, there's bad news: top-line CPI rose 0.7% last month, the highest since September 2005's anomalous 1.2% surge. As a result, the CPI's annual pace as of May is a worrisome 2.7%. More troubling than the absolute level, is the trend. Since late last year, the CPI's annual rate of change has been climbing. As recently as last October, annual CPI was a mere 1.3%, which is lower by more than half when compared with the current inflation.

But optimism has a savior in the core CPI reading, which extracts the troublesome energy and food prices from the mix. By that standard, all is well. In a bubble universe where no one buys energy and food, inflation is worth barely a mention. The 0.1% rise in the core CPI last month was lower than April's 0.2%. In fact, the annual change in the core CPI through May is notable mainly for its descent over time. For the fourth month running, the 12-month change in the core CPI has fallen, posting just 2.3% for May, down from 2.9% in September 2006.

The question then becomes: which one speaks the truth? The answer, depends on each individual's perspective. Indeed, the central bank has a fondness for the core reading because it conveniently strips out the biggest pricing variable over which the Fed has no control: energy. Of course, this is true, so there's a case to be made for central banks focusing on the core. The hope, and it's not entirely unjustified, is that the Fed can execute a prudent monetary policy by ignoring food, and energy prices. If so, the benefits will eventually flow to the economy overall. By that standard, we can all rest easy.

But will reality eventually intrude and spoil that conceptual package? OPEC may be the mother of all exogenous pricing shocks that the Fed ignores in its appointed rounds. But, the masses can't afford such a cavalier view on energy prices.

It remains to be seen how long a divergence between the top-line, and the core CPI will run with no material impact on monetary or political policies. But this much is clear: if top-line CPI moves higher for long enough, there will be a political price to pay, in which case an economic impact, intended or not, may soon follow.

It's hard to imagine that Federal Reserve Chairman Bernanke won't find himself on the losing side of the debate in Congressional testimony if the top-line CPI runs at 3%-plus in the near future, even as the core CPI remains contained. The econometric logic that rationalizes a focus on core as a monetary signpost is lost on the man at the pump paying $60 to refuel his car. Members of Congress will spontaneously sympathize with their constituents on such issues, which in turn will foster calls to do whatever is necessary to relieve the financial suffering.

Invariably, the political pressure to bring relief to consumers paying more for energy runs the risk of stoking inflation. The connective tissue that binds the political to the economic isn't always obvious, but history suggests that the former will invariably affect the latter. In theory, the Fed could abet such pressures by refraining from an interest rate hike, or even lowering rates when monetary prudence suggests otherwise. Barring that, Congress may see fit to engage in an ambitious new program to redistribute wealth to the stricken masses paying more for gasoline. The opportunities for reactionary populist notions are endless in an energy bull market.

Don't let the serene core CPI fool you. The rise in top-line inflation, if it continues, will have consequences for the economy. Ideally, the top-line number will turn down, or at least stabilize, in concert with the top-line number. Until, and if that state of correlation arrives, there's reason to wonder what's coming.