By Chris Cermak

WASHINGTON (MNI) – The unexpected increase in core U.S. inflation
in May could catch the attention of senior Federal Reserve officials,
who have until now cautioned against reading too much into headline
inflation gains over the last few months.

Fed Chairman Ben Bernanke has argued that inflation increases are
“transitory,” the result of an uptick in more volatile food and energy
prices, as some hawkish Fed presidents have sounded the alarm on the
basis that commodity price gains could pass through to broader consumer
prices.

The May inflation figures released this week offered some
ammunition for both sides ahead of the FOMC meeting next week. The price
of commodities peaked in May and has begun to pull down headline CPI,
which rose 0.2% during the month. Drops in energy and food could push
headline inflation into negative territory in June.

Yet core CPI ticked up 0.3% in May, the most since July 2008,
according to data released Wednesday, putting year-over-year core at
1.5%. The rise caught nearly all economists off guard, led by gains in
apparel, motor vehicles and hotels.

“The market was under-appreciating the more broadly-based build in
inflation pressures,” says John Herrmann, senior fixed income analyst
with State Street, one of the very few who predicted the 0.3% rise in
core CPI. “Our models kept suggesting that there were greater pressures
in posted categories that people weren’t quite looking for.”

Herrmann, in an interview with Market News International, predicts
a few more months of “lingering inflation pressures on the core” that
will keep the year-on-year rate between 1.5% and 1.7%, on the low end of
the Fed’s unofficial target range.

The core CPI gain defied a moderating trend showing up in PPI data
for May released Tuesday, where the core and headline index rose 0.2%.
Food prices plunged 1.4%, the sharpest drop since June of last year,
while energy rose 1.5%, the smallest gain since September.

Energy prices in CPI fell 1% on a seasonally adjusted basis, while
food prices climbed 0.4%.

The latest monthly data suggests there may be some limited
pass-through from commodities to core prices. But a one-month trend does
not yet have all economists warning that a more sustained increase in
core inflation is on the cards.

Sean Incremona, senior economist with 4Cast Inc, says core CPI
clearly came in “above trend,” though he adds that “the trend is
firming.” Headline CPI by contrast is expected to slow in the next few
months as energy and food prices continue moderating.

“The hawks might have to switch sides now,” using core CPI instead
of headline to sound the alarm, he quipped in an interview with Market
News International.

The higher core rate could also give senior Fed officials some
pause if it is backed up by a rise in inflation expectations. But
Jonathan Basile, an economist with Credit Suisse, says expectations have
so far been squarely focused on the rise in gasoline prices, which
topped out in May, at least for now.

Basile is also skeptical that the 0.3% core CPI rate will be
sustained in the coming months, predicting that if anything it will
prove an “outlier” outside the trend of CPI developing in June and
later. Apparel, hotels and autos are all “usual suspects for volatility”
that could ease again in the coming months.

“It doesn’t really fit with the overall economic environment,”
Basile told MNI. “We have too much slack in the labor market for it to
last.”

But State Street’s Hermann argues the U.S. recovery from recession
— even a sluggish one — is exactly what is beginning to show up in
core prices, as businesses begin a “normalization” process after two
years of holding back.

“The recovery now is two years long, and prices typically rise as
the length of the recovery extend,” Hermann told MNI, though he
acknowledges a prolonged “soft patch” in the recovery could prove a
damper on inflation.

Hermann says the higher core rate could put pressure on the Fed to
adopt a formal inflation target to temper long-term inflation
expectations.

While the Fed has been keeping a close eye on prices, senior Fed
officials have so far pointed to the weak pace of recovery as the key
reason for keeping monetary policy accommodative, sounding optimistic
that inflation has yet to become a real threat.

“Inflation has drifted up earlier in the year, but has come down in
recent weeks,” New York Fed President Bill Dudley said last week.

Assuming the rapid buildup in commodities has ended, Dudley said he
“would expect headline inflation to decline to a level closer to our
longer-run objectives.”

— Chris Cermak is a Washington reporter with Need to Know News

** Market News International Washington Bureau: 202-371-2121 **

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