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a more signicant role. This is particularly the case in the United States, an advanced economy in which goods make up only 40% of the consumption basket, with services composing the rest.

On this score, industrial uti- lization rates have been low and unemployment rates high, speaking to ample potential supply that will hold measures of underlying ina- tion at low levels over the next two to three years.

In terms of the direction of ina- tion, however, the critical factor is that margins of slack are diminishing. For example, after drifting sideways for almost a year, the unemployment rate has begun a marked decline, fall- ing by nearly a full percentage point since November 2010.

Concurrently, manufacturing industry utilization rates, well off of their mid-2009 lows but making limited further progress after May of last year, quickened their cyclical ascent in recent months, surpassing August 2008 levels.

an upturn in rents, which gained traction in mid-2010.

As a result of these develop- ments, the year-to-year rate of core CPI ination (excluding food and energy) has risen from a trough of 0.6% during the nal months of 2010 to 1.1% in February; we see it rising to 1.5% at the end of this year and to at least 1.75% by the end of next year.

With food and energy set for larger increases this year (2.5% and 7.0%, respectively), the overall headline CPI is set to rise by 2.3% this year and 2.5% next year.

Inflation Risks

Energy and food prices could fall back for a time, as is often the case after a sharp ascent, perhaps in response to monetary tightening and moderating growth in China or a cooling of political risks in the MENA region. If not, persistently elevated prices in these sectors could have an impact on the broader ination outlook.

Finally, the rental vacancy rate, which peaked in mid-2009, began to fall sharply from the middle of last year. While still high by historical standards, the onset of a declining housing vacancy overhang signaled

Higher energy costs could pass through to non-energy sectors that are intensive energy users, such as transportation services. In addi- tion, particularly as labor markets tighten, higher food and energy

Consumer Price Index



  • Consumer Price Index

  • Consumer Price Index Excluding Food and Energy

Percent Change, Year Ago






  • -


  • -


1/00 1/01 1/02 1/03 1/04 Source: Bureau of Labor Statistics.








costs could pass through more fully to wages. Because labor costs are a signicant portion of total costs for most industries, this development would lead to price pressures for various industry sectors.

Finally, a weak dollar and elevated foreign ination could boost import price ination further, creating more leeway for domestic producers to raise prices.

Fed Policy

None of this is to say that we are on the verge of a 1970s ination outbreak. The Fed remains strongly committed to holding ination near 2% over the long term, but it has been equally committed to raising ination toward 2% in the near term.

In its willingness to allow core ination to rise while the economy strengthens and global ination pressures mount, the Fed may not be playing with re. But it seems at any rate to be playing with matches.

It will be important for the Fed to start raising interest rates, beginning the gradual process of returning monetary policy to a broadly neutral setting, long before the unemploy- ment rate approaches a level that policymakers view as being consis- tent with a fully employed economy.

If the Fed waits too long, misjudging the persistence of commodities-based ination or the levels of resource utilization at which broader ination pressures intensify, an ination dynamic could take hold that would require a more aggressive course of tightening— with risks to the economy.

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