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Worrying about inflation
Bigger-than-expected jump in PPI is worrisome, but may not change the Fed's thinking -- yet.
February 18, 2005: 11:49 AM EST
By Paul R. La Monica, CNN/Money senior writer
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NEW YORK (CNN/Money) - Investors hoping the Federal Reserve might slow the rate of its interest rate hikes soon got an unwelcome shock Friday: prices at the wholesale level showed a surprising jump in January.

Fed Chairman Alan Greenspan and other inflation watchers have more reason to worry now after a bigger-than-expected increase in the government's producer price index (PPI) last month.

What's even more worrisome was that the so-called core PPI, which excludes often volatile energy and food prices, jumped 0.8 percent, much higher than economists' forecasts and the biggest increase in just over six years.

For quite some time, many investors and analysts have been able to discount fears of inflation by saying that the only real inflationary pressures were coming from rising oil prices. But Friday's PPI report seemed to debunk that notion.

"This number clearly is going to be upsetting to the Fed. If it repeats itself next month, they may have to change their stance. The disturbing thing is that it's in the core," said Craig Coats, co-head of fixed income at Keefe, Bruyette & Woods.

But will this report spark the Fed into a more aggressive stance? The central bank raised the target for its key short-term interest rate for the sixth consecutive time earlier this month but maintained that it could keep a "measured" pace, since inflation still appeared to be relatively benign -- a comment that Greenspan echoed in his testimony to Congress this week.

One month doesn't make a trend...

Steven Wieting, senior economist with Citigroup Global Markets, said the report is not too alarming since some of the bigger factors behind the spike in wholesale prices were big jumps in tobacco, alcohol and auto prices. Those are unlikely to be repeated, he said, noting that as such the Fed won't put too much credence in them.

"This is not entirely comforting but you'd need a lot more information than one month's PPI at the turn of the year to worry about inflation," Wieting said.

Still, there was more to the unexpected rise in the "core" PPI than just cigarettes, booze and cars. Communications and related equipment prices rose 0.5 percent while construction machinery and equipment costs jumped 0.9 percent.

So there is a case to be made that the steady increase in energy costs may finally be having a broader impact on overall prices.

"It was a matter of time before the core rate started feeling the effects of increased energy and commodity prices," said Barry Ritholtz, chief market strategist with Maxim Group. "Maybe it's aberrational but maybe it's the start of something more significant."

As a result of the PPI reading, investors are likely to focus even more intently on next week's consumer price index (CPI) report for January. Economists are forecasting that overall CPI and core CPI each rose 0.2 percent.

Greenspan has long maintained that he and other members of the Fed look more closely at what's happening with consumer prices when judging inflation, as opposed to the PPI, which measures prices paid by producers and wholesalers.

And in his semiannual report to Congress this week, Greenspan reiterated that he's not overly concerned about inflation at the consumer level.

"Despite the combination of somewhat slower growth of productivity in recent quarters, higher energy prices, and a decline in the exchange rate for the dollar, core measures of consumer prices have registered only modest increases," Greenspan said in his testimony to Congress.

...but don't expect the Fed to pause soon

But the unexpected jump in wholesale prices could mean that consumer prices for January will be higher than forecast as well. And if that trend continues, this could lead to a more aggressive Fed.

"There is a good chance that CPI will be higher than expected. But the question is not only will the CPI reflect the increase in wholesale inflation but whether it will be carried into subsequent months," said Ashraf Laidi, chief currency analyst with MG Financial Group.

Still, when push comes to shove, there are other things for the Fed to worry about. So even if inflation starts to pick up, it's highly unlikely that the central bank will abandon its measured stance of rate hikes, some analysts said.

"The Fed doesn't have to jack up rates really quickly since other economic indicators are softening," said Maxim's Ritholtz. "Capital expenditures are modest and employment figures are anemic, so the biggest danger the Fed faces is smothering the recovery."

To that end, Jeffrey Saut, chief market strategist with Raymond James, agreed that it's tough to justify bigger rate hikes until there is a sustained improvement in the job market. Only then, he argues, would inflation become a major worry.

"The big concern is future inflation and the Fed is viewing that through the labor market. Wage growth continues to be muted," said Saut.

Most market observers expect another quarter-point hike in the fed funds fate in March and quarter-point boosts by Fed policy-makers in May and June as well.

If that happens, the fed funds rate would be at 3.25 percent, closer to the so-called "neutral" rate, believed to be between 3.5 percent and 4 percent, that should discourage inflation while still stimulating economic growth.

But given the heightened inflation fears, it's looking less likely that the Fed will pause in the summer, as some were hoping it would.

"People had thought the Fed could go to 3.25 percent in June and hold but increased inflation pressures would change their thinking," said Keefe, Bruyette & Woods' Coats.  Top of page


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