Inflation Feels Horrible, But Outlook Is Less Frightening

Soaring food and energy prices make inflation feel much worse than it is, and relief isn’t expected until well into 2009.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

May 19, 2008

Is inflation spinning out of control? Government number crunchers and policymakers cite numbers that don't seem terrible. But anyone who pays the bills for a household or a company knows that the cost of living or running a business is becoming more painful.

We expect the Consumer Price Index (CPI) to rise 4% this year. That's about the same pace as in 2007 and about what we've seen so far in 2008.

Why does if feel much worse than that? One reason is that incomes are struggling to keep up. Wages are increasing just over 3% before inflation. And personal income, which includes wages and salaries as well as bonuses, Social Security payments, dividends, interest income and the like, is up only a tad more than prices.

And the costs of food and energy are soaring. About half of the rise in the CPI this year comes from them, with food prices up about 5% and gasoline up 20% so far this year. Paul Kasriel, an economist with Northern Trust Corp., says, "Things that people buy often are going up."

Excluding food and energy, expect a 2.3% jump in the core CPI, which is a gauge of less volatile prices. Costs of the 75% of household expenditures, excluding food and energy, are rising more slowly and in many cases are falling for a range of goods such as computers, new cars, TVs and apparel. Rents, which are 30% of the total CPI and are used to approximate housing costs for homeowners, are rising slowly.

When will inflation subside? Possibly not for several quarters. But this isn't a repeat of 1973-1981 when the CPI rose 9% a year on average as automatic wage hikes became part of union contracts and spiraled upward. Janet Yellen, president of the Federal Reserve Bank of San Francisco, said in a recent speech, "I see little reason to believe that we have entered, or are about to enter, such a period of stagflation."

The fact is many firms can't boost prices. That's certainly true for homebuilders, automakers, appliance makers, furniture stores, computer makers and retailers. Others are raising prices but not enough to fully offset higher costs. They include delivery services and airlines, despite fuel surcharges and higher fares. One survey shows that 63% of companies in the S&P 500 have raised prices from a year ago. But only 26% say that they've been able to raise prices enough to cover their rising costs

We expect oil prices to moderate later this year. If oil drops to $100 a barrel and gasoline to $3 a gallon, that could break the cycle of rapidly rising energy prices. And the Federal Reserve is cooling inflation expectations, convincing financial markets that it can successfully pilot the economy between the shoals of no growth and high inflation, tweaking interest rates as needed.

Meanwhile, more of the same on inflation spells sub par economic growth, with the gross domestic product growing at a meager 1.5% to 2% annual rate through most of 2009. Diane Swonk, chief economist with Mesirow Financial Services, says, "It's bad news if you're a consumer." With real disposable income likely to be stagnant for a while, households won't spend as much, resulting in a slow, prolonged recovery from the economic downturn.

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