Inflation: Worst Is Behind Us

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The New York Sun

American inflation reached its highest level in more than a quarter-century this summer. The good news is that the worst of the price increases probably is behind us.

The surge in commodities prices, especially for oil and food, drove the year-over-year increase in consumer prices, to 5.6% in July. Now, with the prices of oil, corn, copper, and many other commodities in retreat, the month-to-month changes in the consumer price index will settle down.

The bad news is that the drop in inflation won’t be sudden, because many businesses are trying to pass on their higher costs to their customers. For instance, utilities in Virginia and New Hampshire recently got permission from regulators to raise electricity rates because of increased fuel expenses.

What’s reassuring is the absence of signs that the surge in inflation has triggered a wage-price spiral. Many companies have managed to boost productivity enough to offset much of the increase in their labor costs.

While that’s hardly cause for celebration among workers who have seen their inflation-adjusted pay fall, some of that loss is being regained as the cost of gasoline comes down.

The average cost of all grades of gasoline declined by 37 cents a gallon, or 8.9%, to $3.79 over the five weeks that ended on August 18, according to the Energy Information Administration. During the same period, diesel prices plunged 55 cents a gallon, or almost 12%, to $4.22.

When the Labor Department issues its report next month on the CPI for August, it may show an even higher year-over-year increase than July’s. But that may be the result of a 0.2% decline in the index in August 2007 that will drop out of the year-over-year calculation.

It’s unlikely that falling motor-fuel prices will be enough to cause the overall August CPI to decline, since they account for only 5% of the index.

The break in commodity prices is also good news for Federal Reserve officials, whose prediction that inflation would moderate was based largely on the expectation that such prices wouldn’t rise forever.

Fed officials more closely watch the personal consumption expenditure price index, which is a broader inflation measure than the CPI. At the June 24-25 meeting of the Federal Open Market Committee, most officials said they expected PCE inflation of between 3.8% and 4.2% this year, falling to 2% to 2.3% in 2009.

For interest-rate policy purposes, officials place even more emphasis on core PCE inflation, which excludes food and energy. Their projection for the core measure this year was a 2.2% to 2.4% increase, falling to 2% to 2.2% next year.

A key issue for the Fed is whether the broader CPI rate would fall toward the core measure, or the core measure would rise toward the CPI. Some central banks, including the European Central Bank and the Bank of England, have formal targets for the change in overall inflation rather than for the core, and some officials at those banks have criticized the Fed’s focus on the core.

“Many participants expected that persistent economic slack and a flattening out of energy and other commodity prices in line with futures market prices would cause overall inflation to decline noticeably in 2009 and 2010,” Fed officials said in explanation of their June economic projections.

At the same time, the summary said, a significant majority of FOMC participants “saw the risks to the inflation outlook as skewed to the upside.”

Now, two months later, those risks haven’t disappeared, though they have diminished.

Commodity prices haven’t just stopped rising, they have declined. And so long as the outlook for economic growth is weak in America and Europe, and slowing in many other regions, a quick rebound in commodity prices seems unlikely.

Similarly, productivity growth was strong in the first half of this year, and while slower economic expansion in the second half probably means productivity gains will be smaller, they won’t disappear.

For all this country’s inflation problems, they aren’t as bad as in much of the world. While inflation rates aren’t higher in Europe, wage demands there may make them harder to contain.

Those challenges are nowhere near as bad as those confronting emerging markets. In those economies, food and energy are a much larger share of household expenses than in industrial nations, and so far central banks have not raised interest rates as much as may be needed to curb inflation.

“In emerging and developing countries, inflationary pressures are mounting faster, fueled by soaring commodity prices, above-trend growth, and accommodative macroeconomic policies,” the International Monetary Fund said in its World Economic Outlook released last month.

Inflation is forecast to reach 9.1% in these countries this year, dropping to 7.4% in 2009, the IMF said.

While the American inflation outlook has improved, there is still a risk that something goes wrong. And even if it doesn’t, the Fed’s 2% target for the overnight lending rate is too low to be maintained indefinitely.

That said, it’s “a good time to be patient, because I do think we will see better news on the inflation front,” in part because of falling oil prices, the president of the Minneapolis Federal Reserve Bank, Gary Stern, said Wednesday in an interview.

Let’s hope he’s right.

Mr. Berry is a columnist of Bloomberg News.

The New York Sun

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