Spike In Inflation!?!

Fed Confronts Spike In Inflation:
Consumer Prices Surge, But Stumbling Economy Could Start To Curb Pressure
Economists React: Energy Prices Starting To Pass Through To Retail

By Anton Troianovski and Sudeep Reddy | 17 July 2008

WASHINGTON— Consumer inflation spiked to its highest level in 17 years, even as tentative signs emerged that an anemic economy may be starting to take the edge off oil prices. —Daily Economics Newsletter.

The consumer-price index rose 1.1% in June, the biggest monthly spike since September 2005, following the chaos of Hurricane Katrina. Prices last month were 5% higher than a year before, the Labor Department said, the biggest rise since 1991. "Core" prices, which exclude food and energy, rose 0.3% in June, faster than in the previous two months.

Meanwhile, however, oil fell sharply Wednesday, leaving crude off more than $10 a barrel in the past two trading sessions. And fresh data from the Labor Department suggested paychecks aren't following oil and other prices on their upward march. Federal Reserve officials are hoping they can sustain a delicate balancing act of fighting both quickening inflation and anemic growth at the same time. They must do that at a time of tremendous stress on the country's financial system.

The central bank's dilemma: If it follows the typical prescription for taming inflation— raising interest rates— it could add to the stress on the already weak financial sector and bring on an already threatening recession. If it keeps rates steady, it risks allowing inflation to get out of hand.

The sharp decline in housing prices in the past year has dealt one of the greatest U.S. financial and economic shocks in decades. Yesterday, in a rare bout of positive news after a week of jitters, bank shares soared, helping buoy the overall stock market. Investors turned bullish on oil's fall. They also responded positively to the government's move Tuesday to curb negative bets on the shares of financial stocks, which saw one of their biggest daily rises on record.

For now, most Fed officials believe that as the economy slows this year, demand for goods and services will decline, keeping prices from getting out of hand. So the Fed is putting financial stability and economic growth first, while expressing concern about inflation. On Wednesday, Federal Reserve Chairman Ben Bernanke said in testimony before the House Financial Services Committee that inflation "currently is too high," but most analysts believe that the central bank will keep interest rates steady at 2% for the rest of the year.

The central bank would likely be raising interest rates by now if it weren't for the distress in the financial system. Banks have taken big losses on their mortgage-related investments, and their shares have been pounded. The failure of IndyMac Bank last Friday and the government's move to shore up mortgage titans Fannie Mae and Freddie Mac over the weekend has only added to public unease.

Core Rate Speed-Up

Underlying inflation— the core rate— is now at 2.4% compared with a year earlier, well above the 1.5% to 2% range that Fed officials consider price stability. The speed-up in the core rate "is really an unwelcome piece of news for the Fed," said Zach Pandl, a Lehman Brothers economist. Keeping core inflation in check "is really the objective of monetary policy, and any acceleration, if it continues in the next couple months, is really going to complicate the Fed's decision."

In minutes of the Fed's June policy-board meeting, released Wednesday, most Fed officials indicated that because of inflation concerns, "the next change in the stance of policy could well be an increase" in the Fed's benchmark federal-funds rate, at which banks lend to each other overnight. But the timing of any such increase remains uncertain amid the financial turmoil.

Slower growth in the U.S. economy may be starting to take the boil off a key part of the inflation problem: oil prices.

Oil for August delivery fell $4.14 Wednesday to $134.60 on the New York Mercantile Exchange. Oil futures have now dropped $10.58, or 7.3%, in the past two trading sessions. Oil has surged over the past year in large part due to worries that demand was growing faster than supply could keep up, and specifically whether global markets would have enough oil to sate fast-growing economies.

Signs of decreasing fuel demand in the U.S. pushed prices down yesterday. An Energy Department report showing increased crude stocks in the U.S. also led traders to think that sustained tightness in the market may be ending. The oil market, though, has seen a series of wild swings over the past several weeks, leaving analysts reluctant to say that prices are now turning steadily downward.

Gasoline prices remain high, meanwhile, and the costs are crimping consumers. Tanika Coates of Falls Church, Va., says she finds herself living from paycheck to paycheck. She rarely drives her SUV anymore and thinks she'll have to pull her 9-year-old daughter out of her soccer program. "I think it's going to get worse before it gets better, so I'm just going ahead and preparing myself for the worst," she says. Ms. Coates, 30 years old, says she's lucky that her employer, a Washington nonprofit, pays for her subway fare. Otherwise, she says she'd have to get a new job.

Purchasing Power

Fed officials, according to minutes of their June meeting, agreed that inflation risks had risen as the public comes to expect prices to keep rising, among other factors. But they were divided about the degree to which that dynamic has kicked in and might feed through to wage demands.

Some believe the slowdown in the economy will restrain wages and keep inflation in check.

For now, wages are not rising sharply enough to keep up with inflation. The Labor Department said Wednesday that the average weekly earnings of American workers rose 0.3% in June, but adjusted for inflation fell 0.9%. Real wages decreased 2.4% from June 2007. The drop in real wages means that incomes aren't keeping pace with prices— depressing the purchasing power of consumers. Retail sales were nearly stagnant in June despite the government's emergency stimulus package, according to another report this week.

It's not yet clear whether the recent uptick in price increases in goods and services other than food and energy represents a trend of accelerating inflation. "I don't think this was anything more than a one-month aberration for the core," said David Greenlaw, a Morgan Stanley economist. Other economic data are mixed, too. Separately, the Fed reported on Wednesday that industrial production reversed a downward trend in June, rising 0.5% as a heat wave lifted electricity production and employees at a big car-parts manufacturer ended a strike. But the report didn't necessarily signal much relief.

"In the coming months, industrial production can be expected to weaken again as the temporary factors, which boosted activity in June, wear off," Global Insight economist Nariman Behravesh wrote in a note to clients.



Economists React: Energy Prices Starting To Pass Through To Retail

By Phil Izzo, WSJ | 17 July 2008

Economists and others weigh in on the surge in consumer prices.

• The June inflation data provides absolutely zero comfort to a Fed that as of yesterday looks to have thrown in the towel on inflation. When one looks at the data there is a bit of depressing news for everyone. The headline met our expectations of a 5.0% increase, which was well above the expected 4.5% consensus. If one chooses to ignore headline costs and is a devotee of the core rate, [which exclude food and energy prices,] the annual estimate was fractionally below arriving at 2.5%, well above the upper end of the Feds comfort zone. More importantly, the service component, which comprises 58.7% of the survey, increased 3.7% annually and 5.1% on a 3 month annualized basis. This does suggest that we are begging to observe a passing through of headline costs to the core— Joseph Brusuelas, Merk Investments.


• The June uptick in the core rate provides an early indication that the tidal surge in energy and other commodity costs are trickling through to consumer prices at large. We expect the "pass-through" to intensify over the next year and look for year-on-year core PCE inflation to rise from its current level of 2.1%, to 2.6% in mid-2009.— Kenneth Beauchemin, Global Insight.
  


• It is clear that inflationary pressures are building in the economy due to rising commodity prices and higher import prices more generally. While these increases have not for the most part been passed on at the retail level, it is inevitable that they will be at some point. Car dealers and other retailers cannot continue to absorb rising costs at the wholesale level and not pass some of these increases on to consumers.— Dean Baker, Center for Economic and Policy Research.


• The twin inflation demons, food and energy struck again in June as consumer prices soared. Of course, that is hardly news to the average household who already knows that after filling up the tank and putting food on the table, there is little else left. Just about every food product is rising sharply except the most critical one, sweets. Thankfully, that was flat. As for energy, the government is finally catching up with the huge price increases we have all seen and there was a double-digit rise. Excluding food and energy, the inflation rate was a little less oppressive, but there were some areas where pressures are still building. For those who use the telephone or smoke, the news was pretty bad as well. There were some places where consumer costs were under control. Health care, clothing and motor vehicle prices were tame, at least in June. With consumer costs up 5% over the year it is little wonder that households are depressed.— Naroff Economic Advisors.


• Consumption came in much higher We continue to believe that core inflation will hold reasonably steady over the balance of 2008. This reflects an expectation of continued deceleration in [owners’ equivalent rent] and residential rent as vacant properties are transitioned to the rental market. This anticipated deceleration in the key shelter category of the CPI (which accounts for about 40% of the core!) should help to offset any spillover effects tied to higher food and energy prices. Moreover, wage inflation is decelerating as labor market conditions deteriorate.— David Greenlaw, Morgan Stanley.


• It is unclear at this point whether the pickup in rent inflation is likely to be sustained. Fundamentals for rent inflation are mixed. On the one hand, falling home prices have likely discouraged many would-be homebuyers, increasing the relative demand for renter-occupied housing. On the other hand, some of the massive supply glut in the owner-occupied housing market is likely spilling over into the rental market, restraining price increases.— Zach Pandl, Lehman Brothers.


• While Bernanke may focus on some of the global forces behind food and energy price increases, we believe one of the main drivers of global inflation has been the transmission of easy U.S. monetary policy through relatively fixed exchange rates to the dollar in Asia, the Middle East, and other parts of the world. The Fed will likely play down the core increase, which can be viewed as an offset to April’s below-trend gain. For purposes of forecasting the core, the Fed is now focused on wage gains, which have been relatively subdued and the Fed will likely expect this to remain the case.— RDQ Economics.

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