Is the inflation dragon back?

With the war in the Persian Gulf over and consumer confidence on the rebound, financial markets were ready to turn their attention to that slumbering worry, inflation. One look at the big jump in the so-called core rate of inflation for February, and they freaked. The dragon, they concluded, is ready to breathe fire.

Not so fast. Inflation, it's true, was never really slain. It was only sent into retreat. Even in 1986, when it seemed as if the cost of a barrel of oil wouldn't stop sinking, home prices in California and New York galloped along. Inflation was still with us--and ready to climb. By 1989, when the Federal Reserve Board launched its vaunted "soft-landing" policy to achieve a combination of slow growth and moderating inflation, the price indexes had perked up. Today, after nearly six months of recession coming on the heels of a year and a half of slow growth, the core inflation rate, excluding food and energy costs, registered a 0.7% gain in February and exceeded a 5% annual growth rate for the past six months (charts).

MISSING INGREDIENTS. But this inflation, so far at least, seems different from the runaway inflation of the late 1970s--and is unlikely ever to become so terrifying. For one thing, wages aren't rising in tandem with the price indexes. (Producer prices also ticked up unnervingly in February.) Indeed, wages have been growing more slowly in recent months. What's more, the numbers themselves are suspect. Then there's the dollar, which has climbed 15% against the German mark and 8% against the Japanese yen since Feb. 11. A stronger dollar will hold down import prices.

Finally, the very investors who fret about inflation getting out of control can forestall that outcome. By driving long rates higher, they can dampen growth and curb inflationary tendencies. The risk, of course, is that higher rates will postpone economic recovery, which most economists had figured would be under way by midyear. But what's bad for growth could be good for prices: With the recession not yet over and interest rates moving up, the big gains in incomes and demand needed to fuel inflation aren't on the horizon. "You just don't get inflation by immaculate conception," says Stephen S. Roach, economist at Morgan Stanley & Co.

Try telling that to the worrywarts. For them, consumer prices are painting a dismal picture. After factoring out the more volatile costs of food and energy, prices climbed at a 7.7% annual rate in the three quarters ended in February. The bond market, shifting its concern from recession to inflation, pushed yields on 30-year Treasury bonds up nearly half a percentage point, to 8.4%, over the past month. The February consumer price index news alone pushed the rate close to 8.5%. And the spike in rates spooked the stock market, which had to cope with the added jolt of disappointing profit news from IBM.

Most economists aren't quite so alarmed by the inflation numbers. In fact, even policymakers seem relatively sanguine. Fed Chairman Alan Greenspan and other Fed members believed price pressures had eased enough to let them nudge the federal funds rate down a quarter of a percentage point, to 6%, in early March. And the Fed, reversing more than a year of anemic growth in M2, the broad money gauge, started pumping out more money in February, boosting growth in M2 to an 8.4% annual rate.

That was before the bad signals from the producer and consumer price indexes. Nonetheless, the PPI and CPI right now aren't foremost in policymakers' minds. Officials are looking far more closely at powerful long-term influences over inflation: falling capacity utilization, rising unemployment, stability in world-traded commodity prices, and the rising dollar. All these point to decelerating inflation.

MILD PAY HIKES. Most important is the behavior of wages. The wage-and-salary component of the employment cost index has been sloping gently downward since mid-1990 and should continue to do so. Hourly earnings, meanwhile, actually registered no gain at all in February. "Wages," observes a senior Fed official, represent "by far the toughest area of inflation to crack." The inflation bears have to concede that tamer wage gains likely mean that prices won't spin out of control as in the 1970s. "Even if inflationary expectations start rising and people want to buy in advance, they may not always be able to act on that desire," notes Joel Popkin, head of an economics consulting firm in Washington, D. C.Inflation may not be as bad as it looks, but that doesn't stop economists from wondering why it looks so bad. Some economists speculate that new pricing strategies may be at work. Donald Ratajczak, director of economic forecasting at Georgia State University, says he thinks that more and more businesses, looking at the "multiplicity of pricing by the airlines," have decided to attempt what he calls "price discrimination." Instead of opting for standardized pricing, businesses from lodging companies to furniture and auto manufacturers are trying to boost prices selectively at the start of the year and see if they'll stick. But discounting usually follows, and Ratajczak thinks the price indexes will reflect that retreat later in the year, possibly as soon as April.

Even today, whatever discounting is going on may not be captured by the official numbers. The Bureau of Labor Statistics uses about 100,000 price quotes to construct the CPI each month, but critics still charge that the government's measures aren't an accurate reflection of the real behavior of prices in the economy. How can the BLS, for instance, say that airline fares rose in February, when most evidence seems to point the other way? Indeed, the BLS says that airfares rose 22% from January, 1990, to January, 1991. Yet the Air Transport Assn. reports that revenues per passenger mile, known as yields, rose a mere 0.5% in the year ended in January.

Other price puzzles abound. Some of the biggest gains have been in apparel prices, which have risen at a 12% annual rate over the past three months. The BLS says early introduction of spring fashions may account for the spike. Yet discounting is widespread. Are the gains real? And are they sticking? A year ago, apparel prices spiked--and later fell back.

Of course, some of the recent increases in prices are very real. There were onetime hikes in postage rates and higher excise taxes on liquor. Other categories have been troubling in recent months. Services inflation, for one, remains stubbornly high. Yet even here, there may be hopeful signs. Service industries are under pressure to boost productivity, and if they do so, it would help prices.

DANGEROUS. For now, though, traders and investors are registering their disappointment that the recession doesn't appear to have bought the economy a big "inflation dividend," observes Robert DiClemente, an economist at Salomon Brothers Inc. Most economists expect the CPI and PPI numbers to retreat in coming months. If they don't, the markets are sure to ratchet rates yet higher.

That could be dangerous for an economy that's showing only the barest hints of recovery, with people just now beginning to check out houses and stop in at auto showrooms. Most economists have predicated their forecasts of second-half recovery on long-term interest rates remaining under 8%--even as low as 7 1/2%--but surely not at today's level of nearly 8 1/2%.

As David H. Resler, economist at Nomura Securities International Inc., puts it: "The markets are so forward-looking that they may just prevent the economy from getting back on track." If that happens, inflation may have been dealt a more severe blow than it needed.

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