Caging the Inflation Monster

Why are key price measures rising only modestly despite the energy runup? Credit the housing slump, Fed policy, and Wal-Mart

Buried on the 11th page of the government's June 15 inflation report is a stupefying statistic: From March through May, retail gasoline prices rose at an annual rate of 168.2%. The good news? Inflation pain didn't spread far beyond the pump.

According to the Bureau of Labor Statistics' widely anticipated report, core consumer prices—that is, excluding food and energy—rose just 0.1% in May. That was below most economists' expectations of a 0.2% increase. (The "headline" inflation rate, including food and energy, was 0.7%.)

Wall Street rallied on the news that core prices rose modestly despite the gasoline spike. The Dow Jones industrial average rose more than 85 points, or 0.63%, June 15 to 13,639. The Standard & Poor's 500-stock index and the Nasdaq market index also posted sizable gains.

Red Herring?

Motorists could be forgiven for thinking that prices are getting out of control as they see the digits whiz by at the corner gas station. The truth is, though, that overall inflation is surprisingly well under control. "There really has not been much pass-through," says Stephen Gallagher, chief U.S. economist for Société Générale.

The explanation for inflation's quiescence? First of all, that 168% rate of increase, while technically accurate, is something of a red herring produced by a short, sharp, and temporary runup. Compared to a year earlier, gasoline prices were up only 6%. Better yet, they have already started retreating. Pump prices have fallen 20 cents a gallon since hitting an all-time high of about $3.23 a gallon around Memorial Day weekend, according to the American Automobile Association (AAA) Daily Fuel Gauge Report.

The slump in housing has counteracted the rise in fuel prices, notes Mark Vitner, senior economist for Wachovia (WB). Owners' equivalent rent, which is a measure of housing costs, rose just 0.1% in May, matching the overall increase in core inflation.

Then there's global competition. Many U.S. companies can't raise prices to customers even if their own costs are going up, because if they do they'll lose market share to imports. Gallagher notes that the parts of the economy where inflation really is a problem tend to be ones that are relatively insulated from foreign competition, such as health care and education. That's one reason that most economists oppose import restrictions—they worry that consumers will bear the brunt of any resulting rise in prices.

Cheaper Drugs; No Rate Cut

Wal-Mart Stores (WMT) may have played a bigger than usual part in holding down May's inflation rate, speculates Vitner. The giant discounter has been expanding a program of selling certain generic prescription drugs for $4 a month, and other retailers have followed suit. Medical-care commodity prices were flat in May.

Credit the Federal Reserve, too, for caging the inflation beast. The Fed resisted calls to cut interest rates to keep the housing bust from dragging the economy down, notes Vitner. If the Fed had cut rates, inflation just might have heated up. Now, the economy seems to be regaining momentum after an anemic 0.6% rate of growth in the first quarter, even without interest rate cuts.

Says Vitner, "The best they can do is to not overreact when it appears the economy is being hit with a crisis. In the end, the so-called crises never seem to produce the damage that people fear."

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