Commentary: Surprise! Slowdown + Overcapacity = Inflation

By Peter Coy

Beer will cost an extra quarter this summer at Wrigley Field, where the Chicago Cubs play. Crossing the George Washington Bridge to New York from New Jersey went up to $6 from $4 on Mar. 25. Inc. (AMZN ) has been curtailing discounts on books, music, and videos since last year. And Wendy's International Inc. (WEN ) just took Biggie fries and Biggie drinks off the 99 cents menu at company-owned restaurants. Now, they're $1.19.

Inflation. It defied expectations by staying low through the late 1990s, when many economists believed that the economy was overheating. Now it's defying expectations again by rising in a slowdown. Consumer prices rose 4.4% annually from December to February, up from 2.6% last spring. What's more worrisome is that even the core inflation rate, which excludes volatile food and energy prices, has drifted upward, to 3.1% annually in the December-February quarter. That's up sharply since last summer.

This is bad news for Federal Reserve Chairman Alan Greenspan. Fighting inflation is one of the Fed's primary missions, so it's harder for the central bank to cut rates when inflation picks up. When it cut short-term rates by half a percentage point on Mar. 20, it didn't mention inflation. But just because inflation is on the Fed's back burner doesn't mean it's not heating up. Eventually, "the Fed is going to face a fairly ugly dilemma about whether to use policy to fend off recession, or whether to focus on the possibility that inflation is rising," says Joel Prakken, chairman of Macroeconomic Advisers, a St. Louis economic forecasting firm.

What's behind the inflation runup? In part, it's the delayed release of pent-up pressures from the long expansion. Take the "shelter" component of the Consumer Price Index, which includes owned and rental housing and accounts for 30% of the CPI. For the past few years, housing inflation, as measured by the CPI, stayed low. Now, it's finally registering the big increases in housing costs across the U.S. The price index for owner-occupied housing rose at a 3.6% rate in the six months through February, the fastest since early 1996.

Medical-care inflation is also starting to soar after years of being held down by managed care and industry restructuring. The medical component of the CPI grew at a 5.9% annual clip in the December-February period, up from 4.2% a year earlier. For consumers, the worst probably lies ahead, says John P.

Szabo, a health-care stock analyst at CIBC World Markets in New York. He says employers are likely to pass along more cost increases next year than they have this year, because in a slow economy they can squeeze health benefits and still keep workers.

Just as worrisome, the unwinding of the New Economy boom may itself be contributing to inflation. For the second half of the 1990s, strong productivity growth enabled companies to keep profits high and prices low. From 1994 to 1999, nonfarm labor costs rose at only a 1.3% rate. But in a slowing economy, output per worker grows more slowly. In the last quarter of 2000, nonfarm labor costs rose at a 4.3% annual rate. That could drive inflation up as companies raise prices in an effort to maintain profit margins.

BYE-BYE, FREEBIES. And then there's the dot-com implosion, which adds to inflation by ending online giveaways. Example: Juno Online Services Inc. is limiting access to its free Net service so customers will switch to its $14.95-a-month plan.

To all those factors, add food, which rose 4.8% annually during the December-February quarter, and energy, which rose 16.8% annually during the same time. Wholesale hams are up nearly 40% because foot-and-mouth disease has stopped European imports. Energy could continue to be a problem: While gasoline may be cheaper than it was last summer, electricity is likely to be more expensive if California's power crisis spreads to other states.

Americans have grown used to low inflation. But just as the New Economy boom brought good news on prices, the slowdown may bring the opposite.

Coy is associate economics editor.

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