There was some good news yesterday in an otherwise very disappointing consumer confidence report from the Conference Board. Inflation expectations held steady. This is in contrast to a mid-month jump in the Reuters/University of Michigan's inflation reading — and also in contrast to another rare spike in yesterday's producer price report and wide pressure in last week's report on consumer inflation.

For the past week Federal Reserve officials have been actively addressing inflation expectations which they must somehow keep anchored while interest rates drop and gasoline prices remain high. The current fuel gauge reading from the American Automobile Association shows regular at about $3.15 per gallon, more than 15 cents higher than this time in January and nearly 80 cents higher than a year ago.

But the good news may not last long. Lynn Franco, survey chief of the Conference Board's report, warns the inflation expectations component is very likely to rise as spring arrives and the driving season begins. A look at the graph below does in fact show a rise in expectations from winter to spring with the Conference Board's reading rising 5 tenths on average to 5.2 percent. A 5 tenths rise from the February level of 5.3 percent would put the Conference Board's reading at the third highest level on this chart and also the third highest in 20 years of data, next only to the two months after Hurricane Katrina in 2005 (the giant spike in the middle of the graph). But a 5 tenths gain, despite the force of the trend and despite the ongoing increase in gas prices, is not a sure thing. A look back at the 20 years of data tells a different story at a 4.5 percent average in the winter vs. only 4.6 percent in the spring.

Gas is very likely to be pivotal for inflation expectations. The graph below compares changes in gas prices (red) against inflation expectations (blue), and it shows a convincing match though expectations didn't quite go down as much as gas did in 2006 and through most of 2007, at least until late last year when oil began testing $100 and prices at the pump began, and continue, to accelerate.

A no less convincing match is gas and the overall CPI, which is the graph below. Of course the swings are much greater for gas but the nearly identical month-to-month swings are striking. It's a reminder of the importance of gasoline which makes up about 10 percent of all retail sales.

Food prices are definitely on the rise, extending a two year trend tied in part, as it is for gas, to heavy global demand for food. But inflation expectations, as seen in the graph below, don't seem to react to food. Expectations held steady through 2004 even while food was rising steeply, and expectations rose when gas jumped after Katrina even though food inflation was slowing. The ongoing jump in food is having only a modest impact at most on expectations.

Let's quickly look at two factors that at least can have a theoretical effect on inflation, earnings and money supply. Increased earnings certainly do raise inflation concerns among businesses and the Federal Reserve, but they don't seem to have much impact on consumers’ expectations. The graph below compares the Conference Board measure with changes in average hourly earnings. Expectations held steady while earnings growth was falling in 2004, and two years of subsequent gains in earnings are matched by a mostly flat trend in expectations. Earnings growth has been slowing for the last year, but not inflation expectations which have been rising.

Changes in money supply, as measured by M2 in the graph below, offer a hint of trouble ahead but nothing convincing. Growth in money supply has been trending higher than inflation expectations the last three years. Note that increased money supply at the beginning of the expansion in 2003 is not matched by a rise in inflation expectations, perhaps a positive given the Fed's current efforts to raise banking liquidity.

Inflation expectations remain anchored as long as inflation is not affecting the decisions of consumers or businesses. It's when inflation becomes an important factor in financial planning or when buying decisions are moved up that expectations become unanchored, which of course would be the worst nightmare for the Federal Reserve. Below is a quote last week, published by Market News International, from Dallas Federal Reserve President Richard Fisher, the lone dissenter at the January FOMC:

"What you're seeing is more and more reports and discussion about inflation," Fisher said. "Women and men that run businesses are reading those and they are beginning to think in their own brains, in terms of positioning their companies, how they deal with what is suddenly becoming more and more of a noticeable issue."

Bottom line

Watch for inflation comments from Ben Bernanke at this week's testimony in Washington. The Fed is scrambling to position inflation in a harmless light given the need to stimulate economic growth. Bernanke, perhaps as signaled yesterday by his Fed colleague Frederic Mishkin, may stress the policy importance of core inflation, which of course excludes gas but which in any case has also been on the rise. The Fed's ace, of course, is slower growth itself which it hopes will ease price pressures in general including for gas.

The place to watch on the economic calendar for inflation expectations are the related components of the Conference Board's consumer confidence report, released once a month, and the Reuters/University of Michigan consumer sentiment report, released twice a month. The Michigan reading, as seen in the closing graph below, is definitely on the rise, maybe not a dangerous one but it's unmistakable. One year expectations jumped 3 tenths in mid-February and are up 7 tenths from a year ago.