June 30, 2004

In a video presentation to a London banking audience two weeks ago, Federal Reserve Chairman Alan Greenspan stated that the Federal Reserve would be ready to move more rapidly if inflation began to surface.  He then outlined the areas of concern, from commodity markets, to the seepage of oil prices into everyday costs, and the rise in labor costs per unit of production that would suggest inflation is bubbling. 

A week later, in his confirmation hearing for another term at the Fed, Greenspan said that inflation was not now a concern of the Federal Reserve and that interest rate increases would be measured. 

This week, the Federal Reserve is meeting to determine what policy changes are needed.  At the conclusion on Wednesday, investors are prepared for a quarter point increase in the federal funds target used by the Federal Reserve to aid monetary policy. 

Is there inflation, is inflation not a concern, and why would the Fed raise interest rates anyway?

The last question is the easiest to answer.  Since 2001, the Federal Reserve has encouraged unusually low short term interest rates to jump start a weak economy.  This is appropriate policy for a weak economy. 

Assuming GDP estimates of more than 5 percent gains surface for the spring quarter, economic growth will be nearly 6 percent for the past year.  Job growth is more than a million over that period and appears to be accelerating to more than 200,000 new jobs per month. 

In short, the reason for unusually low short term interest rates no longer exists.  Thus, raising rates to a more normal range (about 1-1.5 percentage points below the 4.75 percent for ten year government notes) is justified even if no early signs of resurging inflation are apparent. 

Now letís move to the more difficult question of what is happening to inflation. 

Last August, my leading inflation indicators began to tingle.  By Christmas, they were jumping up sharply.  Thus, talk about deflation at that time was behind reality.  Pricing power was returning to corporate America.  (At a minimum, corporations were able to retain more of the cost reductions for themselves.)

Some of my key leading inflation indicators are: the value of the dollar against major trading partners, prices of sensitive crude industrial commodities, labor costs per unit of production in manufacturing, the level of capacity utilization for American industry, and the rate of change of that utilization.  Some secondary measures are inventory changes relative to sales, and prices of services, and the persistence of price changes for volatile commodities such as oil and farm prices. 

Except for labor costs per unit of production and capacity utilization, all my indicators were definitely pointing toward higher inflation ahead.  However, too many analysts, including the Federal Reserve, rely too much upon these exceptions and not enough upon the other inflation indicators. 

As measured by price changes from the previous year, inflation for consumers rose from a low of 1.1 percent in December to its current level of 1.7 percent in May.  Even Greenspanís favorite measure of the price deflator for consumer expenditures other than food and energy increased from its December low of 0.8 percent to a current 1.4 percent. 

These are not disturbingly high price changes, but they certainly indicate that something has happened to inflation in the past six months, as my indicators had forewarned. 

Will this trend of accelerating prices continue?

A quick look at the producer price index by stage of processing suggests that further price jumps are ahead.  Since the beginning of the year, intermediate prices for all those materials used to build,  package, and transform products have been growing at more than 0.6 percent per month.  The most recent gains in April and May have been 1.1 percent and 0.9 percent respectively. 

However, the sensitive price changes have turned negative in the past two months.  Commodity inflation has stalling, even for the food and energy prices that have surged in the past year.  The dollar also appears to have found a narrow trading range following a year of plunging values. 

My inflation indicators still are positive, but they are slowing rapidly.  This suggests that inflation probably will rise to slightly more than 2 percent, using the measures cited above, and then stabilize. 

No, the Fed does not need to fight intensifying inflation at this time, but it must hurry to take the stimulus out of the system.  Otherwise, intensifying inflation could reappear before short term interest rates return to normal. 

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