By Carl Steidtmann, chief economist and director, Consumer Business, Deloitte Research

"Inflation is running at the upper end of the Fed’s comfort zone" — Chicago Fed President, Michael Moskow September 26, 2005

 “Energy prices put U.S. monetary policy on the horns of a dilemma” — San Francisco Fed President, Janet Yellen, September 27, 2005

 “I consider inflation risks to be elevated at the moment”  — Atlanta Fed President, Jack Guynn, October 3, 2005

 “The inflation rate is near the upper end of the Fed’s tolerance zone and shows little inclination to go in the other direction.”  — Dallas Fed President, Richard Fisher October 4, 2005

 “I have no doubt that both the FOMC and the market would respond to surprises in core inflation that seem likely to be persistent and indicate a developing inflation problem” — St. Louis Fed President, William Poole, October 4, 2005

It is not often that so many Federal Reserve Bank Presidents speak so publicly and with such unanimity on a single topic. But it should be obvious that the Fed is worried about inflation, and for good reason. Inflation is a little like weight gain. It sneaks up on you when you least expect it. You gain a pound here and a pound there then comes the holiday season and, wham, before you know it you’re 10 pounds over weight. Losing that weight is always a lot harder then gaining it. And so it is with inflation.

Guns and Butter; Highways and Disaster Relief
Disasters of any kind are always inflationary. Disasters destroy the supply side of the economy while giving a boost to demand. Over 1 million barrels of U.S. oil production is still off-line six weeks after Hurricane Katrina blew through the Gulf of Mexico. The result has been soaring prices for energy. While gas prices are up sharply, natural gas prices have nearly doubled from a year ago. As a result, the share of consumer spending for energy has risen from 4.9% to 6.7% of income. Disaster relief will bring additional aggregate demand as $61 billion for Katrina disaster relief has already been approved by Congress with more to come. Payouts by insurance companies are likely to add at least another $30 billion in spending.

Disaster relief is not the only source of soaring government spending. Just before Katrina hit, Congress passed a record breaking highway program that included $286 billion in spending with a record 6,371 specially earmarked projects. The total spending for highway construction will, in real dollars, exceed total spending for the Marshall Plan that helped to rebuild Europe after World War II. What highways and disaster rebuilding require is cement. Coupled with soaring demand from China, is it any wonder that there is a growing shortage of cement in the U.S. or that the price of cement is soaring?

These additional sources of fiscal stimulus come at a time when the Federal government’s budget deficit was already running at 3% of GDP even as the economy was pushing full employment. Defense spending as a share of GDP has risen modestly over the past five years from 3.8% of GDP to 4.7%, still well below the recent peak defense spending years of the late-1980s when 7.5% of GDP went to defense spending.

Gold Prices
While oil prices have gotten all of the press, gold prices are a much better indicator of inflation. In recent years the price of gold has been depressed by a steady decline in the overall rate of inflation and by extensive central bank selling of the stuff in favor of interest-paying US government treasuries.

Since early 2001, the price of gold has steadily climbed higher. A weaker dollar has helped along with the rise in inflationary expectations. At $475 an ounce, the price of gold is higher then at any time since January 1988.  

Unit Labor Costs
Oil price inflation is one thing, but unless rising oil prices can work their way into labor costs, then inflation tends to remain moderate. That has been the case over the past five years where rapidly rising productivity growth has kept a lid on labor costs and inflation. The good news on the labor cost front may be over. In the second quarter of 2005, unit labor costs soared after nearly 3 years of posting small declines. The rise in labor costs is due to a slowdown in productivity growth and soaring benefit costs. Growth in unit labor costs has actually exceeded the growth in the consumer price index, pointing to business margin pressures and higher non-oil related consumer prices in the future.

Is the Fed Behind the Curve?
It has often been said that the role of the Federal Reserve is to take away the punch bowl before the party really gets going. The Fed has traditionally done this by keeping the short term Federal Funds rate above the rate of inflation. In the mid-1970s, following the severe 1973-4 Arab Oil Boycott recession, the Fed jumped the gun and pushed interest rates down faster then the decline in inflation. This overly aggressive move has often been pointed to as one of the primary reasons why the rate of inflation never slowed all that much in the mid-1970s and became an even more severe problem by the end of the decade.

Since the middle of 2002 the Fed has once again allowed the Federal Funds rate to remain below the rate of inflation. By having such an accommodative monetary policy for such an extended period of time the Fed was hoping to steer the economy past the worst economic effects of recession, accounting and financial market scandals, terrorism and war. As a result of this extended period of policy accommodation, the Fed has spent the past 18 months raising short term interest rates in hopes of getting ahead of what already appears to be an acceleration of inflation.

Implications for Business
The financial markets did not take well to the repeated Fed Governors’ warnings about inflation. Since early October, the stock market has sold off and long term interest rates have moved higher. The view that inflation is heading higher was reinforced by the pricing components of the Purchasing Managers Survey and by the sharp rise in import prices for September.

With energy prices up sharply this year, overall inflation is already near the late-1990s peak of 4%. The combination of significant fiscal imbalances, a still accommodative Fed and an economy that is near full employment all point to inflation going higher. While double-digit inflation seems unlikely, inflation rates in the 5-7% range can not be ruled out before Fed policy begins to take hold. A more aggressive Fed could keep inflation under 5% but that scenario would probably require a recession.

With inflation headed higher, the era of cheap credit is behind us. While the risks of recession are still low, they are on the rise. The vast amount of government stimulus that is being placed into the economy coupled with higher prices for their products will push growth up in basic industries like construction, energy and manufacturing. At the same time, the credit sensitive industries like housing, financial services and, to a lesser degree, retailing will suffer.

Based in New York, Carl Steidtmann is Deloitte Research's chief economist and a director of Consumer Business Research.  In 2003 Dr. Steidtmann was selected as one of the 25 most influential consultants by Consulting Magazine for his work in consumer spending forecasting. He earned his Ph.D., master's and bachelor's degrees from the University of Colorado.

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