Alan Reynolds

The core consumer price index (CPI) rose by 0.2 percent in July. The chain-weighted core CPI did not rise at all, following two months of 0.1 percent gains. Yet the fixed-weight version seemed to speed up when compared with last year. Why? Because in 2005 the comparable monthly gains averaged just 0.13 from April through September (a 1.6 percent annual rate). If the increase is the same 0.2 percent in August, the year-to-year increase will nonetheless appear to rise from 2.7 to 2.8 percent, because last year's numbers were so low.

Such misleading percentages are just one reason some economists argue the Federal Reserve has not yet done nearly enough to contain core inflation. Last week's column dealt with another reason -- unit labor costs. But there are so many others that the only way to explain why I find these arguments unpersuasive is to go through them one by one.

The case for much more aggressive Fed tightening was carefully articulated in a Wall Street Journal piece by Mike Darda, chief economist at MKM Partners. He proposes "hiking the fed funds rate to 6 percent with more hikes to follow."

"The strongest case against the Fed's decision to pause," he wrote, "was presented by several forward-looking price-level indicators. ... Gold prices have risen to $135 an ounce on the year, while the dollar has fallen 6 percent against G-6 currencies and inflation-linked bond spreads have widened by 33 basis points." Do those variables predict inflation?

First, gold: The price of gold rose from $272 in August 2001 to $725 in May, before dropping back to $623 lately. If rising gold prices predict inflation, why have we not already seen much higher inflation?

The most astonishing increase in the price of gold -- from $239 in April 1979 to $850 on Jan. 21, 1980 -- was a reflection of current inflation. The CPI excluding energy rose by 11.3 percent from December 1978 to December 1979.

In a February paper for MKM Partners, Darda theorized that only increases above about $475 predict future inflation. His graph shows that gold exceeded $475 in February 1983 ($491), yet inflation fell dramatically after that. Gold next peaked at $500 in December 1987, and Darda therefore compares the latest "gold-price breakout" to 1987, which "foreshadowed more than three years of rising core inflation." During those three years, however, the price of gold fell. Gold was down to $271 in 1999 and $279 in 2000. Yet cheap gold then foreshadowed rising core inflation in 2000 and 2001.

Alan Reynolds

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