Inflation Pressures May Be on the Back Burner, but They Could Heat Up

One word you haven’t heard much since the Federal Reserve cut its benchmark overnight interest rate two weeks ago is inflation.

After warning about wage-price pressures for months, the central bank abruptly declared victory in the fight against inflation Jan. 3, asserting that “inflation pressures remain contained” and weak growth is now a bigger threat.

Nevertheless, some analysts say that even with the economy slowing, inflation pressures will mount over the next few months, with worrisome implications both for the economy and for the Fed’s ability to manage it.

“Inflation is a sleeper issue,” said Ira Kaminow, chief economist at Capital Insights Group. Even if the U.S. economy enters a slump, Kaminow says, accelerating wage pressures could make it harder for the Fed to cut interest rates as much as it would like.

If growth remains moderate, he says, inflation pressures could intensify, possibly enough to bring on a period of “stagflation,” where rapid inflation saps economic growth.

Kaminow’s assessment is based on two premises.

First, inflation pressures in the U.S. typically continue well after the economy has slowed. During the 1970s, for example, wages continued rising through the end of the decade, even after years of recession and slow growth.

Second, inflation pressures have built up so much momentum that it will be longer than usual before that plays out. The cost of wages and benefits together is rising at a 4.3% annual rate, and energy prices still are rippling through the economy.

Even with the slump in manufacturing and computer-related industries, the labor shortage in the U.S. hasn’t begun to abate, according to Joel Popkin, a former Labor Department inflation specialist who now is a private consultant.

A “wage-trend indicator” that Popkin developed for the Bureau of National Affairs to help predict labor market patterns shows that even with the economy slowing, pent-up demand for workers will remain considerable and keep wage pressures high through midyear.

“The slowdown in the economy is not showing up in wages,” Popkin said. He predicts that the core rate of inflation--the overall rise in consumer prices, minus food and energy--will exceed a 3% annual rate by midyear from 2.7% now.

On energy, no matter what the Organization of Petroleum Exporting Countries does to control oil production, experts say prices are apt to remain high because supplies will remain tight and the U.S. has no way to expand its production, refinery and pipeline capacity, either for oil or natural gas.

Finally, if the dollar takes a tumble--and many analysts say it’s poised for a big decline, given the U.S. slowdown--it could push import prices higher, removing some of the competition that has helped keep domestic prices in check.

Not everyone agrees that inflation still poses a problem. John Makin, an American Enterprise Institute economist, argues that because the slowdown stems from overcapacity rather than excess demand, there’s no longer any need to fight inflation.

In fact, Makin counts “a preoccupation with inflation statistics” as one of the “biggest dangers facing policymakers” in trying to stem the current economic slowdown because the price pressures so often persist long after the economy has softened.

“A Fed that clings to a backward-looking inflation index as a guide to monetary policy during an intense recession will come under immense political pressure to abandon low inflation targets over the long run,” he said. “That would be a bad outcome.”

Other economists--and the Fed’s statement issued when it cut interest rates Jan. 3--have suggested that the slowdown itself will reduce inflation pressures, while continuing gains in productivity will help keep inflation in check.

“To date, there is little evidence to suggest that longer-term advances in technology and associated gains in productivity are abating,” the Fed said.

Popkin too says the slowdown eventually will help dampen inflation, but with such strong inflation pressures now in the pipeline, “the question is, how soon will that be?”

Moreover, Popkin says, rising productivity may not be the saving grace that the Fed is presuming. Part of the rise in productivity will ebb now that the economy is slowing--and the remaining gain may be too little to offset inflation.

Kaminow points out that if inflation does threaten to accelerate later this year, the economy won’t benefit from the special factors that helped keep price increases tame in 1998 and early 1999--relatively cheap oil, declining costs for computers and a strong dollar.

January will be a crucial month. The Labor Department’s employment cost index, closely watched by the Fed, is due Jan. 25, and the policy-setting Federal Open Market Committee meets Jan. 30 to 31 to consider another interest rate cut.

Popkin predicts that if the ECI and other indexes show labor costs rising, Fed policymakers will be in a quandary--”finding themselves in the position of having to cut rates in the face of further acceleration of inflation.”

That may seem like a no-brainer, Popkin concedes, but it’s not a risk-free remedy. “Fed policymakers must be thinking that they can come back to deal with inflation later, but we all know how hard that is once you let it build up,” he said.

“There’s always a danger that when the economy slows more rapidly than expected that the Fed will ease too much, leading to overheating later on,” Popkin said. “That’s what happened in 1998 after the Asian crisis, and they had to tighten again.”