After a three-year moratorium, the resurgence of more than 860,000 new jobs in the United States in the first four months of this year alongside an economy roaring ahead at a 5% clip, has left market pundits fretting that the fed might have to aggressively tighten monetary policy in order to head off percolating inflationary pressures. In response, rational expectations concerning inflation have been on the rise, though they remain anchored in the vicinity of 2.5% (as measured by the difference between US Treasuries and inflation-adjusted notes). Certainly, there has been a tight focus on the recent spike in gasoline prices, but there is more at play in the US inflation picture than elevated energy costs. Recent fluctuations in the core consumer price index (CPI), whilst not alarming, do indicate that the inflation spiral has turned the corner. As a result, there is a risk that the Fed has left rates too low for too long, and is falling behind the inflation curve.

It wasn’t too long ago that concerns over disinflationary pressures dominated market headlines. Now that the tables have turned, the stem of the problem stipulated by the Fed has tilted. This tendency has been confirmed since, as from February, some firms have indeed regained their ability to pass along higher prices to consumers. Prices for goods often provide an accurate signal of turning points (Structural breaks) in inflation because service price inflation tends to be more stable than goods price inflation. On this front, goods prices, which had been held down by global competition in the past two years, now appear to be recovering from lost ground. As for the service side of the CPI equation, corporate America has not lost its ability to enforce the externalities on the consumer.

However, several risks such as high oil prices and hampered productivity growth are still lurking on the horizon. Even if the risks do not play out, the disinflation-inflation story is dead. The pressure to raise rates has increased over the last month, after the Federal Government reported that job creation surged in April for the second month and prices rose remarkably in both March and April. However, Greenspan has far taken a different view on Inflation. Testifying to Congress last month, he acknowledged that prices had been rising but said that the overall slack in the economy, translated in terms of higher unemployment and substantial unused factory capacity, made it unlikely that wages or prices were about to rise rapidly. Even if wages did rise, he then added, corporate profits have been so high in the last year that businesses are more likely to absorb the costs than risk losing market share.

Rumors have stipulated that the Fed will start raising rates in August; nevertheless the July kick-off has not emerged as a stunning event. The Fed increased interest rates by 25 basis points increments, thereby normalizing the Feds funds rate from 4% to 4.25 by the end of 2005 – the level that is consistent with stable economic growth and sustainable inflation. Nonetheless, the Fed should not waiver in its commitment to tighten monetary settings, as the margin for error is indeed slim.

Nitish Benimadhu

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