Has the inflation damage already been done?

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As I write this, crude oil is well off its high of $147.50 on July 11. We are all eager for some sustained relief in the oil price. However, the right question at this point is: has the damage already been done?

First, consumer inflation for June 208 in the U.S. was 5.0%. This was the highest reading since May 1991. I have calculated that even if inflation ticks up just 0.1% per month over the next two months, the August reading will be 5.4%. So, the headline number there will be the highest since January 1991. From a political perspective, it will be very difficult for the Fed to ease rates with a reading that high.

Furthermore, Producer Price Index (PPI) is quite high. One can consider inflation ‘in the pipeline’ to be reflected by the finished goods PPI. Only if producers lower their margins significantly, can the finished goods PPI not be considered costs that are in the pipeline to be passed on to consumers. This index has soared from -1.2% in October 2006 to an eye-pooping 9.2% in June 2008.

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The combination of these two trends means that inflation can be expected to rise further from 5.0%. It is highly likely that consumer inflation expectations in the U.S. have become unanchored. This means consumers might now be expecting higher prices into the future and do not see this as a temporary blip. When inflation expectations become unanchored, then, that’s it — the inflation genie is out of the bottle and anything can happen.

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The next few months are critical because after August, the CPI will naturally decline based on year ago data. If oil prices continue down, it could smooth the way to some lower inflation readings after August. But, if consumer inflation expectations are already unanchored, oil becomes a bit less relevant.

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