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Consumer Price Increases Start to Raise Specter of Inflation

After years of relatively dormant price increases, the cost of consumer goods and services has started to perk up, raising the specter of inflation.
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Of all the ills afflicting the U.S. economy since the Great Recession, inflation has been pretty low on the list of things to worry about.

Looks like it's time to add it back on the list.

After years of relatively dormant price increases, the cost of consumer goods and services has started to perk up in the last few months, much to the chagrin of both American households and officials at the Federal Reserve.

Just how worried should you be? Here are a few things to consider.

Why are prices jumping?

Much of the jump is being seen at the supermarket, where food prices rose 0.5 percent in May, the fifth consecutive monthly increase. The ongoing severe drought in California, the source of nearly half of U.S.-grown fruits and vegetables, pushed the prices of those commodities up 1.1 percent last month. With no drought relief in sight, prices are expected to continue rising.

Other food categories are also getting more expensive, according to the latest data from the government. Meat, poultry, fish and eggs surged 1.4 percent.

Fuel prices are also moving higher. Overall, energy prices were up nine-tenths of a percent in May, led by a 2.3 percent jump in electricity prices. Gasoline prices climbed seven-tenths of a percent. Recent militant attacks on Iraqi oil facilities could push gasoline prices higher—just at a time when they typically begin to ease now that refiners have built up supplies of summer blends.

The more worrisome price jump, though, is coming in the so-called core rate of inflation that excludes food and energy prices.

What's up with that? Why do economists talk about "excluding food and energy"? We all have to eat and drive to work.

Yes, we do. And consumers tend to be most sensitive to those price changes because they're much more visible than, say, the increase in average rents or the cost of dry cleaning.

Despite the attention paid to gasoline prices, for example, they make up a relatively small portion (about 5 percent, on average) of the typical household budget. But they have an outsized impact on consumer spending because many people tend to tighten their budgets when they see pump prices jump.

The reason economists and the folks at the Fed are less interested in food and energy is that the prices of those two commodities are usually pretty volatile—jumping up and down month to month, much more than other goods and services. Those ups and downs eventually wash out of the system.

But the latest bout of price rises is hitting the core: Even after excluding food and energy, prices jumped three-tenths of a percent. Airfares are up 4.7 percent from a year ago; car insurance premiums are up 4.8 percent; hospital services are up 6.3 percent; and rents are up 3.1 percent.

So what are the folks at the Fed going to do about it?

The textbook cure for inflation is higher interest rates, which the Fed has been suppressing since the financial crisis in 2008 to get the banking system back on its feet and spur the economy.

With the jobless rate now falling back to the mid-6 percent range, the Fed has already begun easing up on its money pumping machinery by "tapering" off its epic spending spree on Treasury and mortgage bonds. (When it buys those bonds, it pays in cash—which is supposed to make credit cheaper and easier to get.)

The Fed's other main interest rate lever—the so-called federal funds rate—governs the cost of borrowing for banks. That rate has been stuck at near zero since 2008, and most Fed watchers had been expecting rates to stay there for awhile longer. This latest bout of consumer price inflation, though, increases the odds that the Fed will begin boosting interest rates sooner rather than later. However, there was little talk of inflation in the Fed statement on Wednesday aside from the routine mentions also consistent with recent reports.

So is inflation at risk of getting out of control?

So far, it's hard to see that happening. While prices have jumped, there's little evidence that wages are following suit. That kind of 1980s-style combined wage-price spiral is the toughest to reverse; as prices go up, workers demand higher wages, which employers have to pass along in the form of price increases. As the cycle repeats, it gets very hard to stop.

Today, wage inflation is nowhere to be found. Employers are still finding plenty of applicants for each new job they post, and few occupations are seeing significant wage increases.

And with the jobless rate declining, the Fed has a little more room to maneuver interest rates higher to tamp down price inflation before it gathers momentum. The risk, though, is that the global economy is still too weak to sustain much in the way of higher rates.

Things could be worse. In Europe, inflation is falling to near zero, sparking fears of deflation—a prolonged period of falling priceswhich is even worse than rising inflation.

To prevent deflation from taking hold, the European Central Bank recently sent its interest rates into negative territory, charging banks to keep money in the ECB's vaults.

So a little inflation isn't always such a bad thing.