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Inflation: The Fed's Biggest Worry

Action Economics expects a hefty 0.4% April increase for the producer price index amid dollar weakness and commodity price strength

U.S. recession fears have dominated the global economic stage for almost a year. Indeed, the health of the economy was an issue even before the subprime crisis took off in earnest last August. But now there's a new Public Enemy No. 1: inflation.

The threat of an accelerated rise in prices for goods and services apparently has taken over as the primary threat to the economy, as suggested by bond yields surging to fresh highs for the year. Indeed, inflation concerns are becoming more widespread among Federal Reserve policymakers. Recent speeches by Fed officials have taken on a more cautious tone—with oil prices shooting past $126 a barrel, commodity prices hitting record levels, and other economic reports failing to corroborate recession talk convincingly.

But the April report on the consumer price index revealed surprisingly mild month-over-month increases of 0.2% for the headline index and 0.1% for core CPI, which excludes food and energy prices. Will the May 20 release of the April report on the producer price index, a gauge of inflation at the wholesale level, confirm the market's inflation fears?

Action Economics expects the April overall PPI to rise 0.4%, in line with economists' median forecast, while the core index rises 0.2% (median 0.2%).

Energy prices are expected to be fairly flat on the month, with the majority of the current uptrend in energy prices likely to enter the index in May. Food prices are also a wild card, with a big drop in some spot food prices suggesting that the contribution may not be as large to the index as many fear.

Sagging Greenback

The core index is expected to remain firm, as continuing weakness in the dollar and strength in commodity prices will probably continue to filter through to many components of the index through early 2008.

For the core index, there is upward seasonal pressure in the first quarter of each year, as annual price increases kick in with the new calendar year, followed by an unwinding in the ensuing quarters. That certainly has been the case thus far in 2008.

Ongoing strength in headline prices, and continued strength in core rates as well, will continue to needle the policy-setting Federal Open Market Committee, despite the Fed's near-term focus on economic risk, as the central bank faces an inflation problem that likely has greater shelf life than the problems in the financial industry.

The Fed has held off on addressing the inflation threat for now, but hefty price gains will likely still be a problem even after the turmoil in the financial markets is resolved.

Englund is principal director and chief economist for Action Economics. Rupert is managing director of global fixed income analysis for Action Economics .

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