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News > Jobs & Economy
Two-faced inflation
Some inflation gauges flash red, while others stay cool, making the Fed's job that much harder.
June 2, 2004: 3:31 PM EDT
By Mark Gongloff, CNN/Money senior writer

NEW YORK (CNN/Money) - There's been a lot of worry about inflation lately, but not all inflation signals are pointing in the same direction, making the high-stakes job for Alan Greenspan and Co. at the Fed all the more tricky.

The good news
Some recent indicators have shown tame inflation
Indicator What it did 
Commerce's core PCE index +1.4% in the past year 
U. Michigan's 5-year inflation outlook Steady in May 
Labor Department's wage/salary measure +2.5% year over year in 1Q, lowest on record 
 Source:  Bureau of Economic Analysis, University of Michigan, Bureau of Labor Statistics

If inflation is fairly toothless, as the Federal Reserve and most economists believe, then the central bank's go-slow policy on raising rates will work out just fine.

But if those red lights flashing 'inflation' on the economy's dashboard are to be believed, the Fed might be in for a rougher ride than it thinks.

First, the good news: Last week, the Commerce Department said its monthly inflation gauge based on consumer spending, the personal consumption expenditure (PCE) price index, rose 1.4 percent in the past year excluding volatile food and energy prices -- the fastest pace since January 2003, but still relatively tame.

Fed policy-makers, including Chairman Alan Greenspan, pay close attention to this number and are happy to see it hold between 1 and 2 percent, many economists believe.

Analysts widely expect the Fed to raise its target for a key overnight lending rate, currently at the lowest level in more than 40 years, when policy-makers meet on June 29-30, but only by a quarter percentage point, in the belief that inflation is fairly mild.

"Core inflation, while much higher in recent months than we (and Fed officials) expected, is not worrisome in an absolute sense," Goldman Sachs economists wrote in a recent note to clients.

Tame inflation and slowly rising interest rates would be welcome news for many investors. After being punished earlier this year by worries about how aggressively the Fed would raise short-term rates, recent signs of stable prices have helped stocks and bonds recoup some ground.

Meanwhile, long-term inflation expectations are holding steady, according to recent consumer surveys. Inflation expectations can be a self-fulfilling prophecy -- if consumers think prices are going to keep rising, they'll be more willing to pay higher prices now, which could encourage businesses to keep raising prices.

"Stable long-term expectations are a potent headwind against a sharp acceleration in underlying price trends," Citigroup chief economist Robert DiClemente wrote in a recent note.

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Doing the Fed's dirty work

DiClemente also noted that recent job gains haven't totally erased all the jobs lost during the last recession, and that unemployment is still higher than it should be, all of which keeps a lid on wage and salary growth. Since labor costs drive about two-thirds of total inflation pressures, according to most analysts, such "slack" in the labor market means inflation isn't yet roiling.

And if firms keep using technology to wring more work out of fewer workers, as they have been in recent years -- the so-called productivity miracle -- then inflation may never get to a full boil. The economy was booming in the late 1990s, for example, with hundreds of thousands of new workers added every month, and yet inflation stayed tame.

"Labor input costs ... will eventually start to show some upward pressure, but I don't think it's going to be egregious," said David Resler, chief economist at Nomura Securities. "Part of that is productivity, and part of it is that we're in a market that is highly competitive and globalized, limiting the ability of anybody to pass on higher wage costs."

The bad news

Now the bad news: The core consumer price index (CPI), which strips out volatile food and energy costs, rose 1.8 percent in the year ending in April, according to the latest reading from the Bureau of Labor Statistics.

The bad news
But other indicators have shown a recent surge in inflation
Indicator What it did 
Core CPI +3.3% annualized in Feb.-April 
ISM prices paid, supplier deliveries indices At or near 25-year highs in May 
Commerce's wage/salary measure +4.2% year over year in 1Q, more than double the year-ago rate 
 Source:  Bureau of Labor Statistics, ISM, Bureau of Economic Analysis

That was the highest core CPI reading since January 2003, and some details were worrisome: The price gains from February to April, if stretched across 12 months, would be 3.3 percent, a rate not seen since 1993.

And that benign PCE index may not be so benign, according to Morgan Stanley chief U.S. economist Richard Berner. In a note posted to the firm's Web site Tuesday, Berner noted that the PCE includes some government guesses about prices that aren't listed anywhere, such as what your bank charges you for printing up monthly statements.

Stripping out these prices, Berner found, the core PCE index has surged at a 2.3 percent annual rate in the past four months, outside the Fed's safety zone.

"Upside inflation risks may require that the Fed move promptly and perhaps a little more forcefully to ensure that inflation and inflation expectations stay low," Berner wrote.

This week's closely watched manufacturing index from the Institute for Supply Management contained some May inflation numbers that were more obviously alarming. Its "prices paid" measure stayed close to April's 25-year high. Its "supplier deliveries" index, a measure of supply bottlenecks, jumped to a 25-year high.

"Welcome to the supply shock," said Russell Sheldon, senior economist at BMO Nesbitt Burns. "The economy has outgrown last year's conservative expectations by a mile, generating shortages and widespread price hikes that are large and will have to be passed on to consumers."

In the view of Sheldon and some like-minded vigilantes, the Fed's current 1 percent target for the fed funds rate, the overnight lending rate it manipulates to boost or slow down the economy, is far too low, risking much higher inflation in the near future.

Some economists believe the Fed could raise the fed funds rate to 4 percent and still have a neutral policy. The longer it waits, some economists fear, the more likely that rate hikes will come quickly.

Economic Indicators
Alan Greenspan
Federal Reserve

"The Fed has indicated it wants to start out slow, and it probably will," said Joel Naroff, president and chief economist at Naroff Economic Advisors. "But these pressures, as they build, will force the Fed to do at least one [half-percentage-point] move by the end of the year."

Of course, there's also the worry that, if the Fed moves too far too soon, it could tip the economy in the other direction, hurting all those consumers who took on so much debt in the days of low rates.

Back we'd fall, then, into the waiting arms of the deflation monster that had everybody so worked up last year.

"Inflation and deflation in this levered world coexist nearly side-by-side," bond guru Bill Gross, managing director of PIMCO, wrote in a recent note to clients.

"Is it any wonder that in the space of the last six months we have had headline speeches promoting the dangers of deflation only to be followed by fears of accelerating inflation?"  Top of page

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