What Might Derail The Recovery? Inflation Fears, For One Thing

No pain, no gain: It's the inflation fighter's mantra. So far, however, the benefits of America's ninth recession since World War II don't look worth the cost. Despite some improvement in recent months, core inflation was no lower in May than it was when the recession began last July.

To be sure, past business-cycle behavior says that price growth will slow further. However, the improvement is shaping up to be disappointingly small, and looking further out, the economy seems headed back into that age-old battle between growth and inflation.

Fixed-income money managers are acting as if the struggle were already on. The bond market fears that embarking on an economic recovery without clear progress on the price front can only send inflation higher, eroding the returns on a whole range of fixed-income investments. Growing speculation that the recovery could be stronger than expected heightens the worry. The result is high long-term interest rates that threaten growth.

The bond market's fears are partly justified--but not for the months immediately ahead. Clearly, inflation improvement is not finished. After each of the past five recessions, price growth has declined during the first year of recovery. This time should be no different.

In the early stages of an upturn, business productivity improves as companies lift output faster than they put workers back on their payrolls, thus reducing the cost of making a widget. Also, businesses tend to hold the line on prices in order to regain their sales volume.


Judging by the behavior of the consumer price index in May, the recession is beginning to have its typical cyclical impact on inflation. The CPI rose a modest 0.3% last month. Excluding food and energy, which eliminates the impact of the oil shock and temporary fluctuations in farm prices, the CPI increased only 0.2%. Measured over 12-month periods, this core rate of inflation has fallen to 5.1% after hitting 5.7% in February (chart).

Producer prices looked anything but tame in May. However, the month's 0.6% spike in prices of finished goods, including a 0.4% jump excluding food and energy, was caused primarily by onetime aberrations in prices for aircraft and tobacco. During the past year, finished-goods prices are up only 3.4%, and the core rate has been slipping lower in recent months.

The improvement in consumer inflation has come mainly in services, where prices had been especially stubborn. Excluding energy, service inflation has dropped from 6.5% in February to 5.6% in May, led by slowdowns in rents, other homeowners' services, public transportation, personal care, and even a slight slowing in costs of medical care.


Don't expect any upward pressure on prices in the goods-producing sector in the coming months, either. Despite continued signs that manufacturing is firming up, there is still plenty of slack in production capacity and in factory labor markets to allow goods inflation to decline even in a full-fledged manufacturing recovery--although that's still not a sure thing.

Industrial production rose 0.5% in May, the second consecutive monthly gain. However, the advance was less than it appears. Utility output surged 3.9% last month, the result of unusually hot weather. Production in manufacturing alone rose only 0.2%.

Moreover, the April and May gains in factory output were not very broad. An increase in auto production, from extremely low levels to still-low levels, accounted for almost all of the advance (chart).

Foreign trade continues to offer some support to U. S. producers. Exports increased by a sturdy 4.5% in April, to a record $35.6 billion. Imports rose even more, however, widening the trade deficit to $4.8 billion from $4.1 billion in March.

The nascent recovery in housing has also provided some lift, but homebuilding is coming under the mercy of the bond market's inflation fears, which have pushed up long-term interest rates. The housing upturn stalled a bit in May as new starts held steady from April at an annual rate of 982,000. Starts are slightly below where they were in February.

Clearly, operating rates show plenty of room for production to rise without putting pressure on prices. The operating rate in manufacturing had ticked up in April, but it edged lower again in May, to 77.3%. Except for March's reading at 77.2%, capacity utilization was the lowest in more than eight years. Historically, operating rates have to rise to around 83% before generating worries about price pressures.

How fast manufacturing reaches that point will depend largely on the strength of the upturn in consumer spending. For now, retail sales are headed up. They rose a solid 1% in May, but continued gains at that pace in the face of weak income growth, low savings, heavy debt, and declining confidence just don't seem likely.

A bevy of onetime factors may be accounting for the seeming renewal of consumer spending, which has helped to lift production. In addition, some of the recent bounce in output might well be the result of extremely low levels of inventories. Stockpiles of goods at manufacturers, wholesalers, and retailers fell 0.5% in April, the third consecutive monthly drop (chart). Inventories were already low, the result of liquidation that had been under way since the recession began. Some amount of restocking may well be in progress, necessitating increases in output.

In fact, the need to replenish inventories in the face of rising demand is probably the best argument for a strong recovery. However, the economy may turn out to be a loser either way. If the rebound in consumer spending proves to be weak or temporary, the need to boost production will be short-lived. And if the recovery starts looking strong enough to fuel inflation, the bond market will push up interest rates and choke it down.


But despite the relatively sanguine outlook for prices in the months ahead, the bond market's longer-term worries about inflation are partly justified. First of all, the recession's cyclical impact on price growth might turn out to be small and fleeting, particularly if the downturn's end is at hand. The recession has not been sufficiently long or deep to vent price pressures in any big way.

Even if the CPI continues to log subdued monthly gains on the order of May's increase, inflation a year from now would fall to only around 4%, from today's 5% pace. If that turns out to be the starting point for the next inflation cycle, neither the bond market nor the Federal Reserve Board will be very pleased.

Since services are half of the CPI, progress against inflation will depend critically on getting service inflation even lower. In the coming months, that's likely. Services remain in a general profit squeeze, as poor productivity growth keeps unit labor costs high relative to prices. That means more service-sector layoffs loom ahead, service wages will continue to slow down, and service prices will ease as well.

But after this near-term decline, further reduction in service inflation seems destined to be limited by the service sector's long-term failure to improve productivity. During the past decade, the growth in service productivity has been essentially zero. That limits productivity growth and inflation improvement in the overall economy as well.

Another problem is that the economy's long-term potential for growth appears to be edging lower. With the growth trends of productivity and the labor force apparently slipping to slightly above 1% each, the economy over the long haul cannot grow much more than 2% to 2 1/2% per year without generating inflation.

All this adds up to a key point about the outlook. Neither the bond market nor the Fed wants a recovery that is strong enough to generate price pressures. In order to keep inflation under its heel, the Fed is not likely to allow growth to rise above its long-term potential for very long. So if the bond market doesn't put the clamps on the coming recovery, the Fed eventually will.