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Early Inflation Sightings

The latest price reports from the Bureau of Labor Statistics suggest that the U.S. was in good shape on the inflation front when the Sept. 11 tragedy hit. In August, consumer prices rose at only a 0.7% rate. Core inflation--omitting food and energy--was only 2.6%, barely above where it was a year earlier. Such positive inflation news has made it easier for the Federal Reserve to slice interest rates.

But an alternate measure of core inflation, calculated by the Federal Reserve Bank of Cleveland, presents a far less optimistic picture. Each month, the bank calculates what it calls the "median consumer price index," which smoothes out some of the big month-to-month changes, not only in food and energy but also in other commodities that may be distorting the index. The result: Inflation, measured by the median CPI, rose at a 4.2% rate in August. What's worse, the price hikes are accelerating. The median CPI is up by 3.8% over the year ending in August, compared with 2.8% a year earlier.

The implication is that inflation, by conventional measures, may rise soon as well. "The median is a good measure of the medium-term inflation trend," says economist Stephen G. Cecchetti of Ohio State University, who with Michael F. Bryan of the Federal Reserve Bank of Dallas first proposed the median CPI in 1994. Over long periods, both the conventional and median CPI rise at roughly the same rate. But in the short run, the median CPI is less affected by temporary price changes that may not reflect the underlying inflationary trend.

In August, for example, the conventional inflation rate was pulled down by sharp declines in prices not just of food and energy but also of such items as tobacco products and mens' and boys' apparel. Indeed, the price of tobacco products fell at a 37% annual rate in that month, a startling drop that is unlikely to be repeated. In contrast, the median CPI gives less weight to such big but misleading price movements.

This suggests that the Fed may have less of a cushion against inflation than it thinks. "Inflation will now tick up, probably over 3%, in the short term if everything goes well," says Cecchetti, a former research director for the Federal Reserve Bank of New York. Such a rise in inflation could keep long-term bond rates high even as short-term rates are cut. Moreover, higher inflation could force the Fed to raise interest rates faster once the recovery begins.

Still, inflation concerns take a back seat to current problems. "We could easily be in for a rather protracted period of stagnation" says Cecchetti. "It would surely be better to live with a small amount of extra inflation now and worry about it when growth goes back to a steady 3% or more." As fears of recession have risen in the U.S., oil prices have declined on the expectation that consumption of everything from gasoline to jet fuel is going to fall. Indeed, as of Sept. 24, crude oil prices had dropped 22% since the attacks, to $21.50 a barrel.

But instead of worrying about a demand slowdown, perhaps investors should be concerned about a shortfall in supply. According to a Sept. 20 report by Raymond James & Associates in Houston, rising tensions in the Mideast mean there's an 80% chance that U.S. oil supplies will be disrupted in the next two years. Shorter term, it says, there's a 20% to 30% chance of a supply interruption if the U.S. targets terrorist organizations linked to oil-producing countries such as Iraq and Iran.

Since the U.S. imports about 60% of its oil, a reduction in supply from overseas would push prices higher. If oil supplies to the U.S. were to fall by 3 million to 4 million barrels a day, for example, crude oil prices could soar as high as $40 to $50 a barrel, says J. Marshall Adkins, managing director for energy research at Raymond James. Making matters worse, U.S. oil producers are already producing all they can, according to the American Petroleum Institute. And even a recession may not send demand plummeting. By Raymond James's analysis, in the past five decades there were only a few years in which worldwide demand for oil fell.

Of course, predicting the timing of an interruption is tough. So oil prices are likely to jump $4 to $5 when news of an attack hits the wires, Adkins says. Most economists believe that free trade is a plus for growth. Yet free trade is highly controversial, both in the U.S. and in the rest of the world.

Now, a study from the National Bureau of Economic Research examines the factors that make people more likely to favor trade. Analyzing a survey of more than 28,000 people in 23 countries, economists Maria Mayda and Dani Rodrik of Harvard University report the expected result that well-educated folks in well-educated countries are more likely to favor trade, while workers in industries exposed to foreign competition in any country are more likely to be against it.

Surprisingly, however, even well-educated workers in poorer nations tend to be against free trade. This opposition, from those who might be expected to be allies of globalization, may make it more difficult to extend free trade.

Perhaps most significant for the current situation, Mayda and Rodrik find that high levels of nationalism and patriotism are associated with support for protectionism. That suggests that sustained global conflict--which boosts nationalist fervor at home and abroad--could undermine support for free trade. And that could make recovery from the current global downturn more difficult.

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