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Inflation Concern Rears Its Ugly Head

The industrial production/capacity utilization data and crude's surge raise the stakes for Wednesday's CPI report.
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Aside from the glaring exceptions of energy and food, consumer prices are believed to have remained well contained in December. The consumer price index, slated for release on Wednesday, might therefore help quell concerns about inflation that resurfaced after Tuesday's economic data and amid further strength in crude oil prices.


Federal Reserve

reported a solid 0.6% gain in industrial production in December. More disturbing for inflation hawks, the Fed said that capacity utilization, which measures slack in the economy, rose to a five-year high of 80.7%.

Adding to the trouble, the New York Fed said that its index of regional business activity was 20.1 in December, down from 26.3 in November, but still well above its long-term average of about 11.0. The prices paid by manufacturers were little changed, with the index at 46.58, but the prices received index soared to 27.4 from 17.8, and way above the 2005 average of 12.0.

Tuesday's data slightly raised market expectations that the Fed will continue lifting interest rates. A Jan. 31 rate hike is almost fully priced in, and the odds of another hike on March 28 rose to 56% from 52% before the data, according to Miller Tabak.

Long-term bonds, which lose value as inflation rises over time, also came under slight pressure. In recent action, the benchmark 10-year Treasury bond was down 3/32 while its yield, which moves inversely, rose to 4.36%.

"Today's data does raise the question about what the Fed plans to do," says Michael Englund, chief economist at Action Economics. "We're seeing late cycle pressure on prices, which normally appear at this stage, but

which the market had not really focused on yet."

Also in the market's focus were crude futures, recently up 2.3% to a three-month high of $65.40 amid concerns about Iran's nuclear ambitions and reduced Nigerian production.

Energy stocks such as


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were rallying in reaction, but crude's rise helped put downward pressure on major stock proxies.


Dow Jones Industrial Average

was recently down 75.4 points, or 0.69%, at 10,828.47; the

S&P 500

index was down 7.90 points, or 0.6%, at 1279.71; and the

Nasdaq Composite

was losing 19.99 points, or 0.86%, to 2297.05.

Semiconductor stocks, which have led the tech sector and the broad market in January, were also under pressure after broker downgrades of


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, scheduled to post earnings after the close Tuesday, was recently down 1.2%.

Credible Evidence of Inflation

When the Fed first signaled in December that rates were approaching a "neutral" level, it also said it would more intensely monitor economic data and especially "resource utilization" for signs of inflation.

But for many Fed watchers, such as Joel Naroff, president of Naroff Economic Advisors, the key resource constraint monitored by the central bank is labor -- and wage gains have remained below par to date.

In addition, while industrial production may have increased in the final stretch of 2005, consumer spending has shown signs of cooling down, not auguring well for first-quarter production, Naroff notes.

And even if prices may be picking up in the manufacturing sector, the broad economy is somewhat shielded from those, given that two-thirds of the economy is now in the service sector, according to Englund.

Meanwhile, just as rising energy costs inflated headline producer prices in December without seeping to so-called core prices, consumer prices -- excluding food and energy -- are not expected to fuel inflation concerns at the Fed.

Economists expect the December CPI to rise 0.2%, contrasting with November's decline of 0.6%. But the core CPI is seen remaining flat at 0.2%.

For England, this doesn't mean that the Fed will be out of the picture. The Action Economics team believes the Fed will "pause" either after its January rate hike, with the fed funds rate at 4.50%, or after March 28, with the rate at 4.75%.

"That's a typical mid-cycle neutral rate" -- meaning neither restrictive or stimulative for growth -- and they can "pause there until we get credible evidence of inflation picking up," Englund says.

Such evidence likely would be gains in core inflation numbers and employment costs, which would bring the Fed to deliver another series of hikes. But these aren't likely to surface until the later part of 2006, the economist says.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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