Inflation: The Storm Ahead?

Productivity gains or no, prices are heading higher--and the Fed has its work cut out for it

Now the Federal Reserve means business. Sure, the central bank raised rates three times between June and December of last year. But those were simply making up for the hurried cuts made in late 1998 to blunt the effects of the global meltdown in Asia, Latin America, and Russia. But the Feb. 2 quarter-point move is a hike of a different color. This time, the Fed sees not just the specter of inflation but some actual evidence. And, while overall inflation is still relatively low, economists expect the Fed to keep hiking until it's sure the menace has retreated. "The risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future," the Fed said as it announced the rate increase.

Finally, it seems, fast growth, low unemployment, and demand that exceeds supply are doing what they usually do--producing higher prices. Through much of the expansion, rising productivity and falling prices of imports have kept inflation in check. But now prices are acting up--or, in many cases, have stopped falling. So the U.S. may no longer depend on cheap oil, constantly falling computer prices, and commodity deflation. Today, the rest of the globe is rebounding, and as a result, so are prices on everything from copper to semiconductors to clothing.

MILES TO GO. At the same time, the effects of the tightest labor market in 30 years are also beginning to be felt. In the fourth quarter, the employment cost index was up 1.1%, well above consensus forecasts of 0.8%. "The salad days of deflation are over," says Mark M. Zandi, chief economist at RFA/Dismal Sciences Inc. in West Chester, Pa. "It's becoming increasingly clear that deceleration is over as we see accelerating signs of inflation."

As always, what Fed Chairman Alan Greenspan is thinking is paramount. In the past several years, he has become a firm believer in the power of the New Economy to deliver relatively rapid growth without sparking inflation. But he has always maintained that, despite the New Economy's productivity benefits, there are limits to safe growth. Clearly, the 5.8% increase in gross domestic product racked up in the fourth quarter exceeds that rate.

Slowing the economy now will take some doing. "If the Fed is trying to get to the Shangri-la, a soft landing, it's going to take several more rounds of hikes," predicts Ken Goldstein, an economist with the Conference Board, which recently reported that consumer confidence is at a record high. "This economic expansion is not an old man coughing and wheezing to the finish line. It's more like a marathon runner sprinting with several more miles to go."

Just look at recent evidence:

-- January auto sales, released on Feb. 1, indicated that on an annualized basis, the industry would break the record set in 1999, selling in 2000 as many as 17.7 million units.

-- On Feb. 1, the National Association of Purchasing Management said its price index moved from 68.3 to 72.6, the highest level since April, 1995.

-- On Feb. 2, the Commerce Dept. reported that new home sales in December rose more than expected, capping off a second record year in a row.

-- On Jan. 31, Commerce said December consumer spending grew at a 0.8% rate, the fastest in four months.

Meanwhile, the fourth quarter also saw prices inching up on a variety of products. The price deflator component of the GDP showed a fourth-quarter annualized inflation rate of 2.2%, including gains on everything from clothing to health care to housing to computer software.

And the Fed is growing more concerned about the prospect of higher wages. Indeed, while the employment cost index for 1999 rose 3.4%, the same as in 1998, a 1.3% increase in benefits costs resulted in a higher-than-expected fourth-quarter increase in the ECI of 1.1%. That was driven mostly by higher health-care costs, especially from increased use of expensive new drugs. But the cost of fringe benefits, such as paid vacations and retention bonuses, also jumped to their highest level in seven years last quarter. "Labor costs are at the top of the list in terms of what Greenspan is looking at," says James F. O'Sullivan, an economist at J.P. Morgan & Co. "But does that mean it translates into inflation?...The message [in the GDP deflator] is that it probably is starting to come through."

OUT OF OPTIONS. Until now, the economy has been able to absorb the hikes--even the tripling in oil prices between late 1998 and January 2000. As the price of oil flirted with $30 a barrel, some pass-along seemed inevitable. Wholesale home-heating-oil prices, for example, rose a staggering 60% in January alone. That's having a crushing impact in the Northeast, which is far more dependent on heating oil than other regions of the country.

The effect on the transportation sector is massive. Airline earnings are off, and FedEx Corp. and most of the major airlines are adding a surcharge to their prices. Southwest Airlines Co., for example, recently increased its one-way fares by $2 to $4 to help offset rising fuel prices, which are expected to increase $75 million in the first quarter. Still, Chief Financial Officer Gary C. Kelly says the ticket-price increase will likely cover only $10 million to $20 million of the jump in fuel prices.

Even the most efficient companies are running out of ways to avoid raising prices. Take Wal-Mart Stores Inc., which managed to cut prices by $10 billion in its last fiscal year ended Jan. 31. This year Jay Fitzsimmons, senior vice-president of finance, says he fears rising labor and fuel costs could show up in higher vendors' prices. A weaker dollar will also raise the cost of imports from Asia. "Our goal is to at least match the $10 billion in price rollbacks [this fiscal year]," he says. "However, it could be more difficult given the circumstances."

Higher raw-materials costs--including hikes in copper, aluminum, and steel--are taking a toll as well. Baldor Electric Co., an electric-motor maker in Fort Smith, Ark., has seen a 20% jump in copper and aluminum prices over the past year, while steel is up 2% to 3%. So far, the company has been able to offset rising wages with productivity improvements, but increases in raw-material prices can't be covered that way, says Chief Executive John A. McFarland. McFarland predicts that later this year his company will have to pass some of its higher commodity costs on to customers. That would be the first general price hike in five years.

That worries the Fed. And the market now seems to believe that rates could be more than 6% by the end of the year. Will that be enough to slow the runaway economy? Some economists think so and expect the consumer price index to settle back down to 2% by yearend from 2.7% in 1999. But for those looking for tell-tale signs of inflation slowly creeping into the economy, the CPI was at 1.6% in 1998.