Wednesday, October 18, 2006

Decline in Inflation Only Temporary

12-month inflation rates declined dramatically in September in most countries. The decline was particularly dramatic in America, which had the highest inflation rate before. The year over year increase fell from 3.8% to 2.1%. Other countries also saw their inflation rates decline, albeit less dramatically than in the U.S.

Euro-zone inflation fell from 2.3% to 1.7% and Sweden's fell from 1.6% to 1.2%. Britain had the smallest decline in inflation, from 2.5% to 2.4%.

The reason for the universal fall in inflation, and why inflation fell particularly much in America, was the fact that oil prices reached the at the time unprecedented nominal peak of $70 per barrel, as a result of Hurricane Katrina. Because gasoline prices in Europe to a much greater extent is made up of taxes, the effect on gas prices was greatest in America. Now that oil prices are falling, the effect on retail gas prices are for the same reason much more dramatic in America.

However, the inflation rate seems likely to pick up soon even if oil prices remain low, particularly in America when the correction from the peak in energy prices that followed in the months after Katrina is no longer included in the 12 month comparison. This is reflected by the fact that the annualized increase since December last year is 3.4% in America.

Finally, an additional point about "core" inflation: markets apparently rallied because core prices increased only 0.2%. But if you look closer at the details, you see how close it was for the number to rise 0.3%-a number which would have caused the markets to tumble. The index for core prices rose from 206.7 to 207.2, in other words, a 0.242% increase, dangerously close to the 0.25% that would have meant a rounding up to 0.3%. Moreover, the reason why it stayed slightly below 0.25% was that "owner's equivalent rent" only rose 0.3% whereas actual rents rose 0.4%. This being the result of an natural gas prices (higher natural gas prices means lower owner's equivalent rent in the fuzzy math of the Bureau of Labor Statistics). As "owner's equivalent rent" is more than 30% of the core index, an upward adjustment of it with the same amount as actual rent would have put the core increase above 0.25% and would therefore have been rounded up to 0.3%.


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