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The Unkind Price Picture

Why the Fed's going to start tightening -- and keep at it.

Easy as ABC

COCOA BEACH, Fla. -- A

Fed

governor uttered the following words about two months ago.

Important sources of restraint on inflation in the current episode have come from the decline in energy prices over 1997 and 1998; the appreciation of the dollar over the three years through mid-1998 and the resulting decline in non-oil import prices; sharper-than-previous declines in computer prices over the past three years; and a slower rate of increase in health care prices, including the cost of health care insurance. Given that all of these developments have at best a transitory effect on inflation, as the inflation benefits of the shocks dissipate or as the shocks reverse, inflation is likely to rise somewhat. Indeed, virtually every forecast projects a modest rise in broad measures of U.S. inflation this year, reflecting the dissipation or reversal of favorable supply shocks, most importantly the reversal in the path of oil prices, the stabilization of commodity prices and non-oil import prices, and some rebound in health care costs.

The table below maps one of these favorable supply shocks.

And it is pretty easy to see that import prices have turned a corner.

Listen. Your narrator knows you must be tired of hearing this, but it is the most important thing you need to know to make good guesses about Fed policy (and to understand why the New Era types have proven so wrong about the economy and interest rates): The incredibly kind price measures we've seen over the past few years owe much less to being able to buy things on the Internet than they do to the set of supply shocks Fed Governor

Meyer

outlined above.

And now the help from those shocks is dissipating.

Is it a coincidence that the

Center for International Business Cycle Research's

Leading Inflation Index went from falling at a 3.2% annual rate in February 1998 to rising at a 4.5% annual rate now?

No. It isn't. That's what happens when energy prices, computer prices, medical-care prices, non-oil import prices, and commodity prices quit falling at faster and faster rates: The overall price picture grows less kind.

And that is why the notions that (a) the Fed is waiting to see the May

CPI

to figure out whether it will tighten at the end of the month and (b) that the Fed will stop at just one tightening are both warped.

In terms of (b),

Jim Griffin

puts it best.

If there is a case for the Fed to tighten at all, why would it do so just once? What is the difference -- in terms of growth pace, price stability, employment levels, and trade balance -- between a Fed funds target set at 4.75% or 5%? Will that small pebble send ripples across the financial markets that will dissuade people from buying cars and houses? Not likely.

And the (a) notion is just plain laughable. Are there really people out there who think that

Greenspan

is preparing two speeches ahead of his Thursday testimony? That he will say "The jury is hereby instructed to disregard every rate-hike hint that every Fed member delivered during the past fortnight" if the core CPI prints less than trend, and that he will use the three-Cs language (phrasing like "the committee will have to consider carefully" is usually standard for rate hikes) only if it prints above it?

Get real.

As the economists at

Goldman

remind, the

TheStreet Recommends

FOMC

tends to reach its decisions after surveying the landscape over months, not weeks.

And for months now, the overall price picture has grown less kind against a backdrop of still-strong demand and still-strong labor markets.

The Fed is right to tighten -- and keep tightening -- for as long as that's the case.

Play Me

Something to keep in mind for Wednesday.

The core (excluding food and energy)

Consumer Price Index

has

printed 0.4% or bigger only thrice since 1992.

It printed 0.5% in October 1992.

Then it printed 0.3% the next month.

It printed 0.4% in April 1993.

Then it printed 0.3% the next month.

It printed 0.4% in January 1995.

Then it printed 0.3% the next month.

So, come Wednesday, is it possible that we will see the core CPI for May print a tiny 0.1% following an April increase of 0.4%?

Hell yes. These are gubmint statistics; anything's possible.

But what little big-core history there is suggests it ain't likely.

Side Dish

Your correspondent thought

Kudlow

was the biggest simpleton guest host ever.

Until today.

Best Franco-American lunch?

SpaghettiOs.

Beef RavioliOs.

SpaghettiOs with Franks.

SpaghettiOs with Meatballs.

Would rather risk eating at Arby's.