Stubborn Prices Are Making Recovery An Uphill Battle

As if the recession weren't enough of a problem for the economy, you can now throw on another worry: inflation. Yes, oil prices have fallen, but inflation elsewhere continues to accelerate. Yes, inflation always declines in the wake of a recession, but until broader progress becomes evident, interest rates will remain high. That means an economic recovery will have a harder time getting off the ground, and even when it does, it might lack staying power.

On the surface, the latest inflation reports don't look so bad. The consumer price index rose a slim 0.2% in February, as energy prices fell 4%. The producer price index for finished goods, those ready for final markup, dropped for the third consecutive month. However, excluding the volatile energy and food sectors, the CPI jumped 0.7% in February, after soaring 0.8% in January, and the PPI posted worrisome rises in both months as well. Through February, the core rate of consumer inflation has accelerated to 5.6%, the fastest 12-month pace in more than eight years (chart).

To be sure, inflation is far less frightening than the January and February reports suggest. One-time factors explain some of the most recent price hikes. Higher taxes on cigarettes and alcohol, the postage hike, and earlier-than-usual introduction of costlier spring clothing took their tolls.

Still, the unrelenting rise in core inflation highlights the stubbornness of the problem. For example, prices for public transportation are up 14.3% from a year ago. Medical care costs have jumped 9.5%. Educational expenses have risen 7.7%. And renters' costs are up 7.6%.


The disappointing news on prices puts the Federal Reserve Board back in a familiar, and uncomfortable, position: It has less maneuvering room to ease monetary policy. If the bond market, where long-term interest rates are determined, believes that inflation is still a problem, it will react negatively to more Fed easing by pushing long rates higher. That concern was clear from the bond markets' sell-off following the government's report on the CPI on Mar. 19, which drove rates up sharply.

So the decline in interest rates is probably over for a while. The Fed will be disinclined to ease more until it sees either some downbeat news on the economy that would justify another cut in short-term rates or better-looking price indexes that would soothe the bond market's inflation jitters. That's especially true in light of the apparent disagreement within the Fed over the need for the Mar. 8 cut in the federal funds rate.

The problem is, the current level of consumer interest rates for car loans and home mortgages isn't likely to spark much of a recovery in factories or housing.

Housing starts jumped 16.4% in February, to an annual rate of 989,000 (chart), but there's little evidence that the rise is the beginning of a full-fledged recovery. The weather was relatively mild in February, compared with January's worse-than-usual chill, and almost all of the February advance occurred in a single region.

Housing starts in the Midwest soared 77% in February, but that came after a sharp drop in January. Taken together, the region's homebuilding in the past two months is equal to its pace throughout most of 1990. Midwest housing isn't suffering as much as the rest of the country, partly because the region didn't join in the homebuilding surge in the years right after the 1981-82 recession. So the Midwest has fewer new homes for sale or rent than elsewhere.

Three trends in February--warm weather, lower mortgage rates, and optimism about the war--probably spurred home buying. That helped to clear out some of the overhang of unsold new homes and give new construction a boost. But February starts were still 32.2% below their year-ago pace. Also, mortgage rates started to rise in early March, and temperatures dipped back to more seasonal levels, suggesting that housing starts may have resumed their downhill slide.


Although the bad news on homebuilding and other sectors of the economy may not be over yet, better readings on inflation seem like a sure thing. But they may take a while. Inflation has fallen as a result of all previous recessions in the postwar era, and the peak-to-trough decline has tended to last nearly two years on average. But this time, inflation's stubbornness is rooted in services, where many prices tend to be less sensitive to the business cycle, compared with the prices of goods.

Inflation in nonenergy services, which make up about half of the CPI, has risen to 6.5% during the past year, from 5.2% in the previous 12 months. That acceleration has occurred even though the economy has been in a recession since last summer. And without a slowdown in the pace of service prices, the overall reduction in inflation this year will be limited.

Some help is on the way. Even though service prices have been rising rapidly, until recently unit labor costs in services were going up faster, because there were no gains in service productivity to offset wage increases. Now, the pace of service wages is slowing, and eventually that should allow prices to abate as well. But with service productivity still poor, it will be a slow process.


Until then, the economy will have to rely on a slower pace of goods prices for most of the improvement in inflation. That's where demand is the weakest and where the recession has hit the hardest. The slumps in housing and autos, in particular, have caused sharp cutbacks in output and operating rates. Indeed, industrial production fell a steep 0.8% in February. The decline was larger than January's 0.5% drop, and it was the fifth in a row.

All the major sectors cut output in February, and almost all are producing at levels below a year ago. Factory output fell by 0.8%, with big losses in the steel, auto, and lumber industries. The February decline means that factory production so far in the first quarter is running at an annual rate of 9% below its pace of the fourth quarter, when it dropped 7.5%.

The output losses would be even greater if not for the strength in exports, which absorb a record 20% of industrial output. Exports rose by $1.2 billion in January, to $34.5 billion, and they are up 9.9% from a year ago.

Increased foreign demand has also helped to shrink the trade deficit during the past year, but in January imports rose $1.9 billion, causing the trade gap to widen to $7 billion from $6.3 billion in December. Still, imports have declined during the past year, and weak domestic demand should keep that trend in place.

Fewer domestic orders also mean that less capacity is being used. Operating rates for all industry declined to a four-year low of 79.1% in February (chart). Manufacturers are using just 78% of their production facilities--a sharp drop from the 83% rate of a year ago.

The steep drop in operating rates is one reason why goods inflation should improve considerably in the months ahead. To get assembly lines rolling again, factories will have to cut prices to attract new demand.


However, stores and warehouses already seem to have more than enough goods on hand. In January, inventories at factories, wholesalers, and retailers were up a modest 0.4%, to $814.4 billion. Manufacturers are keeping a keen eye on inventories, but stockpiles elsewhere are on the rise. Retail inventories were up by 0.7% in January, and wholesale stockpiles rose a troubling 0.9%.

Inventories in both sectors are growing faster than sales. In fact, their inventory-to-sales ratios are higher than they were in the beginning of the last recession.

For consumers, however, excess inventories may reverse some of the recent inflation pickup in the months ahead. Retailers may have to cut prices to clear away merchandise. Until then, wholesalers and retailers are unlikely to boost their orders of manufactured goods.

In that kind of environment, upward pressure on goods prices will continue to ease. But until service prices begin to slow down, the pace of improvement in inflation is likely to be disappointingly slow, interest rates will remain uncomfortably high, and a sustained economic recovery may have to wait.

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