Inflation Isn't Dead Yet

Don't be deceived by Alan Greenspan's unconcerned tone and by the reassuring CPI numbers: This beast knows how to play possum

By Amey Stone

Consumer price inflation, now running at a modest 1.7% annual rate, isn't anything to lose sleep over. But it isn't worth celebrating either. Nonetheless, investors cheered on June 15 when May's core consumer price index came in at a tame 0.2%, a bit lower than feared. The Dow Jones industrial average climbed 46 points, to 10,380, and the yield on the 10-year Treasury bond, which falls as bond prices rise, dropped to 4.68%, from 4.88% the day earlier.

It also lifted investors' spirits on June 15 that Fed Chairman Alan Greenspan seemed relatively complacent about inflationary pressures when he spoke before the Senate Banking Committee (see BW Online, 6/16/04, "Greenspan: What, Me Worry?"). When pressed during the Q&A period of his testimony on his plan for "measured" policy, he said inflationary pressures are "not likely to be a serious concern ahead."

The consensus among investors is that the Fed will hike short-term rates a quarter-percentage point, or 25 basis points, when it meets on June 30 -- not the 50 basis points bond traders were starting to price in just days earlier. But has the inflation monster, which woke up with a start this year after a long sleep, really been tamed so easily? Not necessarily.


  Although the core CPI slightly dipped in May, most of this year has marked inflation's rapid acceleration off the bottom. And one month's data does not a trend make, warn some economists. In the first five months of 2004, core CPI grew at a 2.9% rate, vs. a 1.1% rate for all of last year, according to the Labor Dept.

"When you see the trend shift like it has over the past several months, it's clear we're in a new environment," says David Gitlitz, chief economist at research boutique Trend Macrolytics. "That's what the Fed should focus on -- not that today's core CPI was 0.2%, vs. 0.3%."

Plus, since policy changes take a while to affect the economy, Gitlitz thinks the Fed should base its decisions on where inflation is likely to be in a year or two, not where it is now, or else the central bank risks falling behind the inflation curve.


  It seems like only yesterday (in fact, it was March) that Greenspan was worrying about the impact of falling prices. That was at a point when signs of inflation were starting to show up. "I'm far from an inflation hawk, but I think he has been unrealistic in the last year or so," says Dean Baker, co-director of the Center for Economic & Policy Research in Washington. When Greenspan was worrying about deflation in March, "it was hard for me ever to see that threat," he says.

Inflation remains real and obvious in many goods, including prices for energy, real estate, health care, even milk. Clothing prices, which suffered steep price deflation for most of the past five years, also have jumped this year.

John Lonski, chief economist at Moody's Investors Service, points to recent reports from the New York and Philadelphia Federal Reserve bank districts that show manufacturers are newly able to pass through price hikes. "That by itself is an early indication" inflation isn't slowing anytime soon, he says.


  Lonski thinks the Fed may be willing to tolerate a period of higher inflation in order to avoid destabilizing the housing market with the rapid rise in mortgage rates that aggressive rate hikes would trigger. "The problem is that the Fed is already in a sense behind the curve in that it allowed a steep run up in residential real estate prices," he says.

Lonski also points out that the labor market is still far weaker than it was the last time the Fed began a period of rate hikes to slow the economy. The central bank didn't begin to tighten aggressively until payrolls had expanded by 3.3 million from where they were prior to the start of the 1990 recession, says Lonski. But at last count, payrolls were still off by 1.27 million from February, 2001. Given that, he's not surprised Greenspan isn't in a rush.

"Greenspan is stuck between the bond market, which needs the Fed to be a hawk on inflation, and the political market, which needs job creation to continue," says Peter Cohan, an author and venture-capital investor in Marlborough, Mass.


  Baker, too, believes Greenspan is in a tough spot, but for different reasons. Since price inflation isn't being driven by a tight labor market this time around, he doesn't think a hike in rates will solve the problem. "This isn't a wage-price spiral," says Baker. "I don't know if there's a lot you could hope to do with short-term rates."

Baker's expectation is that the Fed will hike rates 25 basis points, while claiming in its comments that it remains vigilant on the inflation front. "What matters most is the statement that accompanies the Fed decision," he says.

The economy is strong, corporate earnings are soaring, and stocks should start to climb, argues Ed Yardeni, chief investment strategist at Prudential Equity Group in a June 15 report to clients. But he concedes, "The biggest risk to this bullish scenario is a surprising increase in the inflation trend in coming months."

As benign as the inflation news seems now, and as relaxed as Greenspan was on June 15, the economy isn't in the clear yet. And the inflation monster may start to growl once again. That would be frightening for everyone: investors, consumers, and policymakers.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

Edited by Beth Belton

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