USA: Headline Inflation is Coming Down Fast

Overview: The sharp drop in energy prices is now feeding into headline inflation, rapidly reducing the annual inflation rate. Consumer prices were flat on the month in September, in line with our forecast (DB 0.0%, consensus 0.1%) while the annual headline inflation rate declined to 4.9% from 5.4%. Core inflation increased a modest 0.141% on the month (DB: 0.2% m/m, consensus 0.2% m/m) implying a steady annual rate of 2.5%.

Details: Headline inflation was kept down by energy prices dropping 1.9% on the month, driven by a drop in fuel oil (-5.8%) and gas & electricity (-3.2%) while gasoline prices took a more modest decline (-0.6%). On the other hand, food prices remains relatively elevated, rising 0.6% m/m on a broad based rise in various food products. Looking ahead, the upward trend in food prices is likely to moderate or even reverse in coming months as food raw materials prices have come down significantly in the past month.

Core service prices (ex. food, energy and housing) continue to be the driver of core inflation, rising 0.2% m/m, while core goods prices declined 0.2% in September following a benign 0.1% in the previous month. There is thus very little evidence that manufacturers are able to pass on rising core goods producer prices to consumers. With a rapidly building slack in the labour market, declining commodity prices and a turnaround in the US dollar, we look for core inflation to edge lower over the course of 2009.

Assessment & Outlook: As commodity prices are declining rapidly, headline inflation will recede very fast from here. We expect headline inflation to drop below 2% by mid 2009, and if oil prices stay at current levels, the risk to our inflation forecast is on the downside.

Lower inflation and the decline in inflation expectations have given the Fed room to manoeuvre; we expect the Fed funds rate to be lowered to 1.00% by year-end. On top of that, the rapid decline in headline inflation will deliver an important support to real incomes in the coming quarters. With consumers facing headwinds from a weaker labour market, tighter credit conditions and negative wealth effects, lower inflation will provide an important cushion to the hit to real private consumption spending.

Danske Bank
http://www.danskebank.com/danskeresearch

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