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Don't Write Off Inflation Threat

If you thought a decline in wholesale inflation might prompt the Federal Reserve to reconsider its interest rate strategy, you'd be wrong.

In December, the producer price index fell 0.7%, its biggest decline since April 2003, as energy prices declined 4.0% and food prices rose just 0.1% after climbing sharply in the wake of four hurricanes. Excluding food and energy, the core PPI gained just 0.1%.

Economists were looking for the headline rate to fall 0.2%, while the core rate was expected to increase by 0.2%.

Ordinarily, inflation numbers like these would provide some support to U.S. Treasuries. But bonds sold off and yields rose on Friday, as investors focused on hawkish remarks from St. Louis Fed President William Poole.

The yield on the 10-year note rose 5 basis points to 4.21%. Stocks advanced, with the Dow up 6 points at 10,511 and the Nasdaq up 6 at 2077.

According to news reports, Poole said the Fed could drop its plan to raise rates at a "measured" pace at some point in the future. So far, the bank has been raising interest rates in quarter-point increments.

Sherry Cooper, chief economist at BMO Nesbitt Burns, doesn't think 50-basis-point moves are on the cards, but she does believe rates will rise from a current level of 2.25%, saying inflation is trending higher, despite last month's data.

"Although inflation problems are not yet pounding on the door, they are steadily walking towards the front entrance," she said.

For all of 2004, the PPI was up 4.1%, a hair more than 2003. But core prices rose at a 2.2% annual pace, twice that of the previous year. In 2002, core prices fell 0.5%.

"With crude oil rebounding towards $48 a barrel recently, the pullback in prices last month looks to be a short-lived," said Cooper.

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