Inflation on the Distant Horizon

Is inflation ahead? The latest barometer readings are confusing. Worrywarts point to the Producer Price Index for finished goods, which rose a more-than-expected 1.4% in January. That follows increases of 0.4% in December and 1.5% in November. This index can be an early warning for consumer prices, though it often flashes a false signal. Those who are less concerned note the Consumer Price Index (CPI), which increased a mere 0.2% in January. That’s the fifth straight month at 0.2%.

We see inflation as a distant threat -- real, but not imminent. What catches our eye are surveys indicating that more companies are starting to raise prices, chiefly in health care, energy, utilities and basic consumer products such as food and medicine. And the latest CPI report, though tame, shows higher prices of some key items, including used cars and medical care.

While price hikes are only being felt in a relatively few categories, there’s enough upward movement to put policymakers at the Federal Reserve on alert. With a still fragile economy, the central bank will wait several months before raising key interest rates. With the recent increase in the Fed’s discount rate, the central bankers are putting investors and borrowers on notice that the days of cheap credit are over. The discount rate hike by itself won’t result in higher borrowing costs for companies or households: It’s sparsely used and affects only banks that seek emergency loans from the Fed. But the increase is the Fed’s first step in a long, gradual march toward higher rates.

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The Fed has some time to wait. Over the past 12 months, the CPI has increased 2.6%, but that’s mainly due to higher energy prices than a year ago. Assuming that energy prices don’t go up much from where they are now, the CPI’s year-over-year increase is likely to ease to 2% during the second half of this year. That’s a rate the Fed would applaud. But in setting monetary policy, its task is to anticipate what’s to come. As the economy shifts from recovery to expansion later this year, the risk of much greater inflation rises, so the central bank likely will begin to tighten credit, resulting in banks raising their prime rate. That’s not likely before late 2010, however.

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