It was only a few months ago that economists and policy-makers were worried about the possibility of a devastating Japanese-style downward spiral in prices. But a surge in employment growth over the past three months and an unexpectedly sharp upturn in consumer prices have revived the prospect of uncomfortably high inflation.
Most analysts consider the latest spike in prices to be a temporary phenomenon caused by retailers and suppliers taking advantage of improving economic conditions to push through long-delayed increases. An increase in oil prices to record levels, which seems to be abating, has for now caused only a mild spillover effect.
But the possibility of persistent, rising inflation clearly is complicating the Federal Reserve’s job as it prepares to begin raising short-term interest rates for the first time in four years. Investors will be watching closely when the Labor Department reports the latest monthly inflation figures Tuesday.
“There is some catch-up here,” said Diane Swonk, chief economist at Bank One in Chicago. “These are industries that went from deflation to being able to put through any kind of price increase. The Fed understands that. They are waiting to find out whether is this a one-time price increase or something more than that.”
A survey of small businesses published this week alarmed some observers, showing the most aggressive pricing behavior since the late 1980s, said William Dunkelberg, chief economist for the National Federation of Independent Business, which conducted the poll.
Of the 587 firms responding, 34 percent said they had raised prices within the past three months, only 8 percent had cut prices and 31 percent were planning price hikes. That compares with a year ago when only 18 percent had raised prices recently, 15 percent had cut prices and 20 percent were planning price increases.
“At a minimum you have what I characterize as a relief rally in prices,” Dunkelberg said. “They are raising prices mostly because they can and haven’t been able to for several years.”
That assessment rings true in the steel industry, where a confluence of factors is allowing producers to raise prices from their lowest levels in 20 years, said Ronald Sandmeyer Jr., chief executive officer of Sandmeyer Steel in Philadelphia.
Strong demand from China has helped drain the global supply of raw materials for making steel, including scrap iron, he said. In addition, the declining dollar has made the United States a less attractive market for foreign steel producers, he said.
“There is less price competition from imports coming in,” Sandmeyer said. “That has given all manufacturers more breathing room to raise prices across the board.”
Makers of stainless steel like his family-owned company have been able to push through a series of three or four price increases this year, at 1 to 3 percent each time. And the price hikes have stuck: Makers of industrial machinery need more stainless steel because they are boosting capital spending for the first time in years, spurred by rising profits and an expiring tax break for investment.
Fed will do 'what is required'
Fed Chairman Alan Greenspan and other central bankers made it crystal clear this week that they are watching the inflation trend carefully. Consumer prices — even after excluding volatile items like gasoline — have risen at an annual rate of 3 percent so far this year, compared with last year’s 1.1 percent, the lowest level in 38 years.
Greenspan briefly shook financial markets when he reminded traders that Fed policy-makers will “do what is required to fulfill our obligations to achieve the maintenance of price stability.” The comment was a hint that while the Fed plans to raise rates in a “measured” fashion from current 46-year lows it will act more aggressively if needed to tamp out rising inflation.
Other policy-makers agreed, including St. Louis Fed President William Poole, who was quoted as saying the Fed might have to raise interest rates faster than expected if inflation proves persistent.
“There is a very substantial amount of uncertainty about where we are going to go, and it is going to be important for the Federal Reserve to be prepared to respond to new information ... if we end up with inflation coming in on the high side of expectations," Poole told the Reuters news agency.
"If it looks like the signal is really there, then my personal position would be that it would be appropriate for the FOMC (Federal Open Market Committee) to move further and faster than priced-in in the market today," said Poole.
The Fed is expected to raise its benchmark overnight lending rate from 1 percent to 1.25 percent June 30, the first of an expected series of rate hikes that could bring the rate to 1.75 percent by the end of this year and 3.25 percent by the end of 2005, said Steven Wieting, senior economist for Citigroup.
But so far he and other analysts do not anticipate a repeat of the 1994-95 episode, when the Greenspan-led Fed raised the federal funds rate from 3 percent to 6 percent in one year and nearly derailed the nascent recovery.
“The idea that this has to be a really nasty piece of tightening — the evidence isn’t that clear yet,” Wieting said.
Economic conditions are quite different than they were a decade ago, and the Fed seems determined to give a much clearer signal of its intentions. That makes it likely the Fed will move slowly this year, but the outlook for 2005 and beyond is less certain.
Greenspan's legacy
Wieting points out that recent surveys of consumer sentiment have found little change in long-term inflation expectations, even as consumers face the reality of sharply rising prices at the gas pump and elsewhere.
“If we find that businesses and consumers are accepting higher inflation as an ongoing phenomenon, that is when the Fed becomes very concerned,” Wieting said.
Swonk said the course of rate hikes could be influenced by Greenspan’s desire to leave office on a high note. While Greenspan presumably will be confirmed by the Senate next week for a fifth term as Fed chairman, he probably will step down when his current term as governor ends in early 2006, just before his 80th birthday. Greenspan will not be eligible for reappointment.
That might mean Greenspan will leave much of the heavy lifting on interest rates to his successor.
“Look for inflation to pick up more rapidly, and the Fed to act more aggressively, once we get beyond 2005,” Swonk said in a monthly report. “Enjoy the next 18 to 24 months, as we might look back on them as the best of [the decade].”