INFLATION UPDATE, AUGUST 2008

Wall Street seems convinced the Federal Reserve will begin raising interest rates later this year. The growing concern is that in the face of soaring energy and food prices, people are starting to believe higher inflation is here to stay. The fear is that these inflationary expectations could alter wage and price setting behavior. That would cause inflation to become ingrained, spreading beyond energy and food, just as it did in the 1970's. Many investors believe the Fed has no choice but to raise interest rates to keep inflation in check.

What is missing from this argument, are the strong labor markets necessary to generate a widespread inflationary spiral. Rising inflationary expectations cannot push prices up broadly unless the job markets are strong enough to lift wages enough to maintain consumer's purchasing power. That was the case in the 1970's: Prior to that decade's two broad accelerations in inflation (outside of food and energy), unemployment was declining while wages and salaries (adjusted for overall inflation) were growing about 6.00% annually.

Flash forward to 2008: The mix of rising unemployment and soaring gas prices is sharply eroding the purchasing power of consumers. Payrolls are shrinking and the growth in inflation-adjusted wages and salaries has fallen to just shy of zero.

The squeeze will get worse in the second half of 2008. Overall inflation in May was running at 4.10% annually, and by late summer, economists expect rising gasoline prices will push it above 5.00%. All the while, core inflation, which excludes energy and food, has been edging lower all year, because higher food and gasoline prices are reducing the demand for other types of goods and services.

Much of the pressure on U.S. inflation is coming from overseas, but it's the labor-market differences between the U.S. and economies abroad that will determine the U.S. inflation outlook and the Fed's policy actions. In Europe the link between prices and wages is much tighter, given the stronger influence of powerful unions to negotiate cost-of-living increases and rigid rules on hiring and firing.

By contrast, U.S. jobs and wages respond more quickly to weak demand, which means the labor market outlook is not good. The domestic economy would have to expand 2.00% to 2.50% to generate the job growth necessary to hold unemployment steady. However, the domestic economy only grew at a 1.50% pace in the first half of 2008. Under that scenario, the unemployment rate will approach 6.00% by year-end and the growth of wages and salaries will slow further, even as higher food and energy costs reduce the discretionary income of consumers.

In an economy this weak, if higher overall inflation is driven only by energy and food, it's more apt to help control core inflation than push it higher. If the weakness persists, growing slack in the labor markets will dampen the inflation outlook and preclude the need for interest rate hikes later this year.

Excerpts taken from the "Business Outlook" article written by James Cooper, page 12, July 14th, 2008 Issue of BusinessWeek Magazine.

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