updated 1/21/2005 5:12:18 PM ET 2005-01-21T22:12:18

Excluding energy, consumer prices rose a modest 2.2 percent last year, according to year-end government figures released this week. But that seemingly benign figure conceals growing inflation pressures that could bedevil policy-makers this year, some economists believe.

By any measure inflation is accelerating. The so-called "core" inflation rate, which ignores food and energy costs, rose 2.2 percent compared with 1.1 percent in 2003, when the possibility of deflation became the dominant concern for Federal Reserve Chairman Alan Greenspan and his colleagues. Overall consumer prices rose 3.3 percent last year, up from 1.9 percent in 2003.

But last year's increases understate the true inflationary pressures, said Anirvan Banerji, research director of the Economic Cycle Research Institute.

“Inflation pressures are simmering more than most people acknowledge,” he said.

He observes that for so-called “tradable” goods, such as apparel, electronics, cars and furniture, inflation is declining or prices actually are falling, especially when adjusted for rising quality. To put it another way, manufacturers and retailers have no pricing power in industries where there is a “China price.”

But service-related areas are largely immune to these forces of globalization, and they are subject to growing inflation as the expansion ages. College tuition is perhaps the prime example. Tuition and fees are up 42 percent over the past five years, a period in which overall prices have risen only 13 percent. The costs of medical care and personal services also are rising much faster than inflation.

Banerji compares the situation to the old economist’s joke about a man with one foot in a bucket of ice water and one foot in a bucket of boiling water. On average, he is quite comfortable.

“Of course we’re not going to go to 1970s-style inflation — that is obvious,” he said. “But that does not mean that inflation is benign.”

With virtually every major economy in the world expanding, any excess capacity will be soaked up quickly, resulting in higher prices of imported goods. The falling dollar makes the situation worse, increased pressure on import prices.

Also, there are signs that unit labor costs are rising for the first time in nearly three years, said Larry Horwitz, senior economist at Decision Economics.

“Since labor costs dominate the weight of any other costs for business, when unit labor costs rise that really does indicate a lot of margin pressure and the chance we will see higher prices,” he said.

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Horwitz and others pointed out that rising inflation is hardly unexpected: The economy has entered the fourth year of an expansion and is expected to show strong growth this year, even if not quite as robust as in 2004.

“I don’t think anybody, most importantly the Fed,  is going to push the panic button as inflation rises a bit," Horwitz said.

Still, the prospect of higher inflation is clearly on Fed radar screens.

“I recognize that on the surface, some of the recent price statistics might seem to present little cause for alarm,” Cleveland Fed President Sandra Pianalto said this week.

“But in my opinion the momentum in the inflationary process has clearly shifted away from disinflation,” she said. “And unfortunately it is not always possible to distinguish short-term movements … from the emergence of an inflationary trend until after the fact.”

For that reason, she argued that the Fed needs to be vigilant about inflation as it raises rates from unusually low levels. Similarly Philadelphia Fed President Anthony Santomero warned that the Fed will need to consider “quickening the pace” of rate hikes “if signs of price pressure emerge on a consistent basis.”

This kind of talk, reinforcing the tone of Fed minutes released this month , has a growing number of forecasters predicting that policy-makers will continue to raise rates at every scheduled meeting for the foreseeable future, as they have done since June 30.

Analysts expect another quarter-point hike in the benchmark short-term rate at  the upcoming meeting Feb. 1 and 2, and some are beginning to talk about bigger moves down the road.

The Fed is on the verge of “upping the ante, at least rhetorically,” said Michael Englund, chief economist for Action Economics. “In the past Greenspan has often capped a tightening cycle with an above-average tightening.”

The current tightening cycle is clearly a long way from its conclusion, and the coming year looks promising.

“As long as this is a pretty resilient expansion, the Fed can afford to take the risks and raise rates without fear of triggering a recession,” Banerji said.

But danger could lurk on the horizon. An economy that has been boosted by an unprecedented amount of fiscal and monetary stimulus could come back to reality with a thud.

The Fed already has raised short-term interest rates 1.25 percentage points and could raise them another two points this year, according to some analysts. In the past, such sharp rate hikes always have triggered recessions. Meanwhile Congress will be under growing pressure to cut spending and bring down the deficit after one of the biggest budget expansions in history.

While it is hardly a scientific observation, Banerji pointed out that since World War II every Republican president has experienced economic problems in the second year of each term.

“If you look at the leading indexes, we are probably going to be all right in the near term,” he said. “Over the long term there are some more interesting signals.”

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