0.3% Consumer Price Gain Lulls Inflation Fears

U.S. consumer prices rose modestly in July, but the 0.3% increase--the first in three months--did not convince economists that America’s long, virtually inflation-free expansion is nearing an end.

“Nobody [thinks] that the fires are smoldering and inflation is about to break out,” said Don Ratajczak, director of the Economic Forecasting Center at Georgia State University.

The consumer price index for July, released by the Labor Department on Tuesday, seemed to reassure financial markets, easing earlier fears that the economy might be showing signs of overheating.

That, in turn, could have prompted a significant interest rate increase by the Federal Reserve next week. As it is, analysts expect a modest quarter-point increase, to 5.25%, despite the lack of evidence of inflation in Tuesday’s numbers.

The report suggested that the main thing affecting U.S. consumer prices at the moment is the energy sector. Oil and gasoline prices are volatile and have climbed lately as oil-exporting nations cut back on production.

“If you exclude energy prices, then we’re running at 2% annual inflation, and that’s a 33-year low,” said Gerald D. Cohen, senior economist at Merrill Lynch.

Also driving July’s consumer price increase was a large increase in tobacco prices, which have shot up as cigarette manufacturers pass on the cost of recent litigation to smokers.

The Fed’s Open Market Committee raised the federal funds rate, which it sets for banks to make short-term loans to each other, a quarter-point June 30 amid growing concern over the tight labor market voiced by Federal Reserve Chairman Alan Greenspan.

Since then, reports of rising employment costs and a slowdown in productivity gains have persuaded market analysts that further rate hikes are a foregone conclusion and that Greenspan will have to move further to preempt any inflation pressures.

But that picture has been muddied by Tuesday’s CPI report. Some argued that any increase is unjustified, and several analysts said they now expect the Fed to raise rates by no more than a quarter-point when it meets next Tuesday.

Ratajczak called a tightening of that size a “baby step,” and questioned whether even that much is justified, given the absence of clear inflationary pressure.

James K. Galbraith, an economist at the University of Texas, was even more pointed, saying it would be outrageous if the Fed based a small interest rate rise on such scanty evidence of inflation. He said that while slightly higher interest rates wouldn’t trigger a recession, they would hurt the working poor, particularly those who barely qualify for home mortgages and car loans at current interest rates.

July’s consumer price figures leave economists at as much of a loss as ever to explain how the U.S. economy can show month after month of strong growth and job creation without reviving inflation. In recent memory, inflation has tended to pick up whenever the unemployment rate has dipped below 6% or 7%. The jobless rate has fallen below 4.5%, and it is still hard to find any statistical sign that inflation poses a threat.

“We’ve all been scratching our heads here,” said Robert V. DiClemente, head of economic market analysis for Salomon Smith Barney. “It’s not normal.”

Analysts suspect that part of the explanation lies in increased worker productivity. They say recent advances in technology have increased worker output so much that companies can raise wages without having to pass on the cost in the form of price increases. This, in turn, has given rise to a theory that America has crossed a threshold and is enjoying a technology-driven “new economy” that doesn’t respond in the traditional manner to the wage-inflation relationships of old.

But the theory cannot be tested quickly, since productivity is notoriously difficult to measure.

“It will probably be years before we really understand what happened in the 1990s,” DiClemente said.

In the meantime, analysts are watching for signs that the “new economy” remains vulnerable to traditional pressures: that wages will begin to rise faster than productivity gains or that the rising cost of certain raw materials will eventually feed through into consumer prices.

Economists also are looking hard at the renewed strength of countries that slumped last year, thinking that as they return to economic health, their products will become costlier for Americans to buy. That could also fuel inflation in the United States.

So far, there is anecdotal evidence of such labor shortages and raw-materials bottlenecks in America and renewed growth overseas, but it has not shown up in the broad statistical measures.

“A yellow warning light has been blinking,” said Merrill Lynch’s Cohen. “You hear about shortages. You read about them. But so far, you haven’t seen them in the prices.”