Commentary: Don't Cry over a Little Inflation

By Rich Miller

After years of hibernation, the inflation bears are starting to growl. A surprise 0.5% jump in consumer prices in April--the largest in nearly a year--drove the annualized inflation rate over the last three months above 4%. Couple that with the Federal Reserve's lax monetary policy, and the inflation-phobes argue that the U.S. economy may be in for a debilitating spike in prices. "Long-run inflation risks are rising," says Banc of America Securities Chief Economist Mickey D. Levy. His prescription: an aggressive regime of interest-rate hikes by the Fed.

Levy and his fellow bears should relax. Sure, inflation can pose dangers for the economy. Look at the 1970s. But after a year of inflation at rock-bottom levels, the return of a bit of pricing power is nothing to dread. Indeed, it may be just what's needed to ensure that the expansion has staying power.

How so? Well, corporate chieftains are shell-shocked after last year's collapse in profits. So they're holding back from hiring and from forking over money for capital investment. And even as the economy picks up, there's little sign of a profits surge. But without healthier earnings, the recovery could be stunted later this year as the current growth spurt--which has stemmed largely from the need to replenish inventories--wears off.

That's where a little pricing power would come in handy. With costs already cut to the bone, strong profits are unlikely until companies are able to start boosting prices again. And only then will companies resume spending on computers and other efficiency-enhancing equipment--spending that will be key to the durability of the recovery. The higher prices that would result in the short term would be a cost well worth taking and one that Fed Chairman Alan Greenspan, for one, seems willing to bear. With inflation over the past year running well below 2%, the benefits of a return to 2 1/2% or so appears to well outweigh the risks.

Corporate coffers wouldn't be the only beneficiary. A pinch of inflation would help ensure that the U.S. steers well clear of the dangers of deflation, the wasting disease afflicting Japan over the past five years. Indeed, Japanese consumers still refrain from buying goods in anticipation of lower prices in the future, a phenomenon that has bogged down the economy for years. "When you have inflation rising so slowly, the greater risk is deflation," says John B. Brynjolfsson, executive vice-president of Pacific Investment Management Co., a bond investment firm.

In fact, by most measures, the inflation rate is falling this year, not rising--even as economic growth accelerates. A surfeit of capacity throughout the economy means that most companies have little or no pricing power--many continue to be forced to cut prices. The personal consumption expenditure price index, the inflation measure favored by the Fed because it takes account of shifting consumer tastes, has risen by a mere 0.8% over the past year. "Inflation is returning to levels not seen on a sustained basis since the early 1960s," says James Glassman, senior economist at J.P. Morgan Securities in New York.

Of course, the April surge in the consumer price index was a surprise. But much of the increase came from higher prices for gasoline and cigarettes--two factors that are likely to reverse in May. What's more, some of the price increases showing up in the CPI should be welcomed as a sign that the economy is on the mend.

That's certainly true of hotel charges, which jumped 1.6% in April, as travelers continued to shake off the effects of September 11. Airline fares also have risen this year after falling sharply in the latter half of 2002.

To be sure, there's always a risk that inflation can spiral out of control once it starts to accelerate. But as long as strong productivity growth keeps labor costs in check, price pressures aren't likely to take off. And that's why a little inflation now is no reason to lose sleep.

Miller covers economic policy from Washington

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