What's Taking the Air Out of Inflation

Soaring energy and food costs are pushing up overall inflation. But they're leaving consumers so strapped that businesses lack pricing power

Economists of all stripes tell you inflation will never get out of hand as long as people expect it to stay down. The 1970s were a disaster because businesses began making decisions on everything from purchasing to production to inventory levels based on the belief that prices would be far higher in the coming year. Unions bid up wages, and rising incomes fueled more demand and ever-higher prices, all while historically easy monetary policy greased the economy's wheels down that slippery slope.

Fast-forward to 2008. Driven by energy and food, the yearly inflation rate for consumer prices jumped to 3.9% in April from 2.6% a year ago, and April producer prices looked troublesome. A Reuters/University of Michigan survey of consumer inflation expectations in May showed that households think inflation a year from now will be 5.2%, the fastest projected rate since 1992; in the next 5 to 10 years, they see it averaging 3.3%, their highest long-run assessment since 1996.

Kansas City Federal Reserve President Thomas M. Hoenig recently cautioned against a growing "inflation psychology" that could embed higher inflation into the economy. Wells Fargo (WFC) economist Michael J. Swanson goes a step further, saying in a May 19 research note: "The Federal Reserve has lost the battle to control consumer and worker inflation expectations."

Really? Maybe it's time to step back from the headlines about $130 for a barrel of oil, $4 for a gallon of gas, and more than $4 for a box of Cheerios, and consider the dour economic landscape across which these inflation worries are rising. The economy has barely grown for two quarters, and the weakness is far from played out. Jobs and hours worked are falling as businesses cut production and capital spending. The annual growth rate of wages and salaries, adjusted for inflation, has fallen to zero from 3.7% at this time last year. And consumers shoulder the added burdens of falling home prices and tighter credit.

Weaker Consumer Spending

The point here is that households may expect energy and food to push overall inflation higher, yet consumers' expectations cannot generate a '70s-style inflation psychology because spending on those two items requires so much sacrifice elsewhere. Last quarter, consumer spending outside of energy and food was the weakest in 13 years. This broad slump in demand is cutting deeply into business sales and profits, forcing cost cutting. Unlike the 1970s, wages and prices cannot push each other higher, so inflation remains confined to energy and food.

Even after three years of rapid price growth in energy and food, core inflation—which excludes those two items—is no higher than a year ago and remains below where it was two years ago. In the past three months core inflation has slowed sharply, rising at only a 1.2% annual rate, suggesting weaker demand is already having some impact.

The squeeze on demand will get worse. The 15% surge in pump prices since the end of March, to a U.S. average of $3.77 a gallon on May 19, is crimping budgets even more. Current crude quotes mean prices will average more than $4 a gallon this summer and approach $5 in some areas. That rise will push overall inflation above 4% in coming months and will negate a major portion of the positive effect of this year's tax rebates.

Clues in Bond Yields

Bond investors, who are extremely sensitive to how inflation can erode the value of a fixed return, appear to understand all this. The difference between the yield on a 10-year Treasury bond and a 10-year Treasury Inflation-Protected Security—which is the rate of inflation investors expect over the life of the bond—is 2.4 percentage points. That's the same as the average over the past three years.

The downside of this benign outlook outside of energy and food is that it might require several quarters of sub-par economic growth to assure that prices stay broadly contained. Still, given the protracted problems in the housing and credit markets, that's the most likely scenario.

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