Inflation Gauges Are Spinning, but Don't Panic -- Yet

As much as people would like to think it's dead or dying, inflation isn't even resting comfortably anymore.

Many on Wall Street figure sluggish demand and rising unemployment means inflation won't be a problem -- not for a long time. But after the Federal Reserve's aggressive rate cuts of the past five months, the inflation hawks are beginning to swarm. They're thinking the incentive to spend, prompted by lower rates, will ultimately fuel an explosion in prices.

Who's right will depend on the strength or weakness of the economy in the next couple of quarters.

The Delicate Edge

Despite the ongoing economic slowdown, consumers have generally kept up a relatively healthy pace of shopping. Corporations, on the other hand, have slashed their capital spending and other budgets to cope with the sharp downturn in orders. As a way of enticing both consumers and businesses to step up their spending, the Fed has cut rates five times since Jan. 3, bringing short-term rates down by 2.5 percentage points,

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If buying really picks up and demand rises, prices will likely follow higher.

Rising costs aren't just a concern when it comes to goods. It's also related to labor. Unemployment was below 4% just a few months ago, a generational low. To keep talent in their buildings, companies raise wages. Average hourly earnings are rising at an annual rate of 4.3%, a three-year high. More expensive payrolls give companies an incentive to jack up prices. But because of slack demand, businesses haven't been able to raise prices as they typically would to pay for rising wage costs. Instead, profits are getting squeezed.

Core consumer inflation is rising at a 2.6% annual rate, just off a four-year high. In part, housing and medical costs drive prices higher, according to the most recent reading of the Consumer Price Index. And energy costs are also jumping.

With the sagging economy prompting a rise in unemployment -- it climbed to 4.5% in April -- and business demand lethargic, economists don't expect general price pressures to be a problem in the next several months. Core inflation -- which excludes volatile food and energy prices -- is a lagging indicator. As the economy falters, prices are usually marked down (those who believe inflation won't be a problem figure the slowing will cause prices to come down due to weakened demand).

The recent move in crude producer prices confirms this trend. Producer prices refer to the rawest of all raw materials companies use to make their stuff (think Paul Bunyan selling trees). Excluding volatile food and energy, they are down 12% over the past 12 months. Raw goods account for only a small part of company costs, but these costs are a leading indicator -- prices for finished goods will follow the trend for unfinished goods.

Slack-Jobbed

Economists generally expect the labor market will continue to get softer. While unemployment remains near 30-year lows, payrolls have dropped for two consecutive months. April had the largest one-month decline in jobs in more than 10 years. The expectation is that wage growth will taper off as companies look for ways to offset falling demand for their products, rising energy costs and declining productivity among the nation's workers.

In the harsh reality of economics, rising unemployment creates a slack in the labor market that would be expected to help avoid an inflation spiral several months down the road. Since the Fed has chopped rates in a relatively short period of time, some economists worry there won't be enough time for companies to get their staffing to the most efficient levels that allow them to keep prices rising only modestly.

"If the slowdown is sufficient in opening up slack in the labor market, inflation would start to come down," says Josh Feinman, chief economist at Deutsche Asset Management Americas. "But the lags can be long, and the labor market got so stretched that it may take subpar growth for a while to get the labor market to where costs are going up at a more normal rate."

All In Good Time, My Pretty

In due time, economic weakness would be expected to alleviate inflation pressures in the labor or goods market. But it's possible the Fed's rapid-fire actions have set the stage for a spike in prices before that slack can be realized.

Clearly, that's what the bond market is saying. Long-term yields, which reflect the market's long-term view of economic growth and inflation, have been on the rise since January. The steepening of the yield curve -- the difference in yields between shorter- and longer-term Treasuries -- is a sign the economy is poised for growth. But this steepening, caused lately by rising yields in the long end of the market, also indicates fears that inflation is going to creep into the picture.

The 30-year bond yield stood at 5.34% on Jan. 2, the day before the Fed began its series of interest-rate cuts. Lately, it was at 5.76%, rallying a bit since Wednesday's CPI for April showed prices increased less than expected. The bond market is suggesting the Fed's efforts will improve the economy's growth, but also that it may be moving too aggressively in its effort to revive the business sector.

In announcing its latest rate cut on Tuesday, the Fed said corporate profitability and the dearth of capital spending continue to be of great concern. But the Fed can't target its rate cuts to just the business sector. Lower interest rates attract wide swaths of consumers and businesses, so spending spurred by the Fed's actions will occur throughout the economy.

The Fed is "trying to boost corporate profits, but in order to boost profits they have to boost demand," says Paul Kasriel, chief U.S. economist at Northern Trust. "That demand will lead to a resumption of demand for labor, which will push up those costs, and they'll be passed through when we have stronger [consumer] demand. The Fed has essentially embarked on a policy likely to result in a wage-price spiral."

If prices do continue to swing higher, inflation will be starting from a higher base than in 1998, the last period when the Fed eased rates.

One well-respected measure of inflation, the Cleveland Fed's median CPI, has been rising at an annual rate of 3.9%. In February, it was 4.2%, the highest since 1996. To be sure, it dropped in the past two months in response to declining demand. But in mid-1998, it stood at just 3.2%. Instead of taking out food and energy prices to find core inflation, the Cleveland Fed's median CPI measure seeks to smooth out one-month anomalies for a better reading of the overall inflation trend.

If inflation does become a problem, the Fed will likely be forced to tighten rates since its practice has been to try to prevent upward price spirals. The concern is, the economy won't be strong enough to handle higher rates. Already, the fed funds futures , the market's best proxy for expectations for Fed policy, is pricing in the possibility of rate hikes by the end of the year.

There's a good chance they'll be right.

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