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The biggest monthly jump in consumer prices since 1982, up 1.1% in June, tightens the screws on the Federal Reserve regarding the next interest rate move. In normal times, the central bank would be preparing to hike rates, but raising rates with the economy as weak as it is amid growing uncertainty about the functioning of the banking sector would be the wrong move.
The Federal Reserve is postponing an inflation fighting hike in short-term interest rates until economic growth picks up, which likely won't happen until 2009. Despite seven rate cuts totaling 3.25 percentage points since last September, mortgage rates are higher and financial markets remain fragile. The latest scare involves the future of virtually insolvent Fannie Mae and Freddie Mac, which hold or back nearly half of the $11 trillion worth of outstanding mortgages in the U.S.
The jump in consumer prices in June isn't a surprise to the Fed whose chairman, Ben Bernanke, told the Senate Banking Committee Tuesday that inflation pressures would "intensify" and that "inflation seems likely to move temporarily higher in the near term." But the Fed is counting on the surge to fade later this year, though it will be watching closely to see whether a growing number of businesses are able to raise prices. The more likely scenario is that with consumers retreating, business sales and profits will suffer.
In fact, the Fed is counting on growth being weak enough the rest of this year that holding off on a rate hike won't be a mistake. But most economists are expecting at least a couple more months of nasty readings like June. The Labor Department said the Consumer Price Index (CPI) rose 1.1%, with two-thirds of that coming from higher energy prices.
The CPI is up 5% over the previous year. That compares with an increase of 4.1% from December 2006 to December 2007. With energy and food prices remaining high, we look for the CPI to increase about 4.5% for the year through December.
In a further disturbing note, prices excluding food and energy went up 0.3%, a bit higher than expected and a warning sign that high energy prices are rippling out. The core CPI is up 2.4% over the past 12 months. The Fed has indicated in the past that it wants to keep the core rate around 2%.
Some members of the Fed have been recently urging a rate hike to offset the inflationary impact of soaring energy prices in the past year. But even those so-called hawks want to see signs the economy is improving instead of stalling. "Helping the financial markets return to normal functioning will continue to be a top priority of the Federal Reserve," Bernanke told the Senate committee in his semiannual testimony on the state of the economy.
Economic weakness is enough of a worry that another rate cut this year can't be ruled out, though it seems unlikely. Lyle Gramley, a former Fed governor, says a rate cut probably wouldn't do much at this point. "The Fed has pushed hard on the accelerator and the engine is still humming along at 30 miles an hour, not 60," he says.
The Fed is probably going to stay on hold as it watches how consumer and business spending do in the aftermath of the tax cut stimulus plan, hoping that exports remain strong and offset housing's decline. Bernanke told senators that consumer spending "is likely to be restrained over the coming quarters" and business spending and hiring are expected to be cautious.
Bernanke underscored the seriousness of the inflation threat and said the rise in energy prices will push inflation "temporarily higher in the near term." The Fed expects that growth will slow during the second half of this year and that "should slow inflation in 2009." Bernanke said the Fed will be vigilant on the inflation front and that it's possible businesses will try to raise prices. But he also noted most companies so far have been unable to pass through higher commodity costs.
The Fed's job is made trickier by the apparent quick spending of $115 billion in individual income tax rebate checks. The jump in consumer spending combined with strong exports point to an increase of about 2.5% in gross domestic product (GDP) in the second quarter, much stronger than the puny 1% increase in the first quarter of this year.
Bernanke said that the Fed had expected a bump in consumer spending from the government stimulus to be spread evenly over the second, third and fourth quarters. Instead, most taxpayers appear to have spent their checks within days or weeks of receiving them. The last of the rebate checks are being delivered in July and consumer spending without that added stimulus will be flat to slightly negative for the rest of the year.
As part of the Bernanke testimony to Congress, the Fed updated its economic outlook and now sees GDP up between 1% to 1.6% this year and 2% to 2.8% in 2009. Thanks to the infusion of the rebate checks, we see an increase of about 1.5% in GDP this year. Without a similar stimulus next year, GDP will rise about 1.5%.
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