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Inflation: U.S. Consumer Price Index to Drop in June

The US consumer price index rose significantly to 3.44% in May from a year ago and 0.2% from its April level. The increase was bang on target with my estimate. However, I believe that May's figure on a year-ago basis approached a plateau in the current cycle.

My analysis indicates that changes in the CPI inflation rate on a year-ago basis and especially CPI ex shelter are explained by changes in the oil price compared to a year ago. It is particularly evident since the end of 2006 where more than 94% of the direction of the CPI ex shelter is explained by the year-on-year absolute change in the price of crude oil.

CPI inflation rate explained
Sources: I-Net Bridge; Plexus Asset Management.

Shelter's weight of approximately 32.3% in the CPI and the one-month lag between the change in the oil price and CPI ex shelter inflation enables me to make a reasonably accurate forecast. The change in the oil price is a known factor while the only unknown factor is the CPI shelter CPI. But with a more stable trend the CPI shelter CPI inflation rate that can be expected is fairly reasonably assumed.

Change in Oil Price
Sources: Bureau of Labor; Plexus Asset Management.

The year-on-year change in Light Louisiana Sweet crude in May was $41.53 per barrel. The historical relationship between the change in the Light Louisiana Sweet crude and the CPI ex shelter inflation rate points to a year-on-year CPI ex shelter inflation rate of 4.77% in June given the said lag. That makes up 67.7% of the overall CPI inflation rate (overall CPI minus the 32.3% weight of the shelter CPI) and will therefore be 3.23%. If I assume a year-on-year change of 1% in the shelter CPI, May's total CPI will add up as follows:

(67.7% of 4.77%) plus (32.3% of 1%) = 3.23% plus 0.32% = 3.55%.

The 3.55% inflation rate means that the consumer price index will drop by 0.1% in June. The first decline since June last year!

But where is CPI inflation heading?

Without taking a stab at where the oil price is heading, I looked at three scenarios where the price per barrel of Louisiana Sweet crude was kept constant at $100, $115 (current) and $130 respectively for the next 12 months. The monthly oil price was then compared to the price a year ago and depicted against the CPI ex shelter inflation rate lagged by one month.

Oil vs CPI ex shelter inflation rate
Sources: Bureau of Labor; I-Net; Plexus Asset Management.

By applying the historical regression equation the trend of future CPI ex shelter year-on-year inflation is as follows:

applying the historical regression equation the trend of future CPI ex shelter year-on-year inflation
Sources: Bureau of Labor; I-Net; Plexus Asset Management.

Assuming that the year-on-year inflation rate for shelter remains steady at 1.0%, the outlook for the overall CPI inflation rate is as follows:

outlook for the overall CPI inflation rate
Sources: Bureau of Labor; I-Net; Plexus Asset Management.

 

  Year-on-year CPI inflation Rate %
@ constant
$115/barrel
@ constant
$130/barrel
@ constant
$100/barrel
May-11 3.44 (actual)
Jun-11 3.55 3.55 3.55
Jul-11 3.32 4.03 2.61
Aug-11 3.15 3.86 2.44
Sep-11 3.44 4.15 2.73
Oct-11 3.01 3.72 2.30
Nov-11 3.02 3.73 2.31
Dec-11 2.85 3.56 2.14
Jan-12 2.51 3.22 1.80
Feb-12 2.11 2.82 1.40
Mar-12 1.55 2.26 0.84
Apr-12 1.35 2.06 0.64

Sources: Bureau of Labor; I-Net; Plexus Asset Management.

It is evident in the above that the US CPI inflation rate is likely to peak at 3.55% in June if the oil price maintains its current level or weaken. Even if the oil price spikes to $130 per barrel and maintains that level, the inflation rate will still top out in July this year. There may be a short further spike in September owing to a brief drop in the oil price in August last year.

 

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