FinancialAdvisor's College Class (FACC)

[FinancialAdvisor]

Inflation, Bottled Up by Fed, Threatens to Burst Its Container

Inflation, Bottled Up by Fed, Threatens to Burst Its Container

Oct. 3 (Bloomberg) -- Inflation, which Federal Reserve policy makers have proclaimed ``well-contained'' at least 11 times this year, is threatening to burst its container.

Rising energy costs are rapidly spilling over into the prices of everything from a bottle of Pepsi-Cola to a room at the Marriott, sparking concern that such increases are seeping into the pricing patterns of companies, and may accelerate throughout the economy.

``The dangers of high energy prices spilling over into core inflation are clearly increasing,'' says former Federal Reserve Governor Lyle Gramley, now a senior economic adviser at Stanford Washington Research Group in Washington.

``Clearly, this risk is having an impact on Fed policy,'' Gramley says. Economists in a Bloomberg survey completed Sept. 8 predicted the Fed would keep raising the federal funds rate to at least 4.5 percent from the current 3.75 percent, and maintain it there through the end of 2006; some see the Fed going as high as 5.5 percent by the end of next year. Previously, economists were expecting the Fed to quit raising rates in the second quarter of next year, and to start cutting in the second half.

In a sign of rising inflation, yields on inflation-indexed 10- year Treasury notes have risen almost 19 basis points, or 0.19 percentage point, since Sept. 5, to 1.763 percent on Sept. 30. The implied yield on the January fed-funds futures contract rose to 4.185 percent Sept. 30 from 3.785 percent at the beginning of the month.

Risking Slower Growth

``The Fed is erring on the side of fighting inflation and is willing to risk slower growth,'' says Gerald Lucas, chief Treasury and agency debt strategist at Banc of America Securities LLC in New York, who forecasts more declines in bond prices, pushing yields higher.

The changing expectations reflect a shift in thinking among some economists who have been dismissing the jump in energy and commodity prices as temporary, focusing instead on the core indexes, which exclude volatile food and energy prices. The consumer price index has risen by 3.6 percent in the past 12 months, its biggest gain in four years; over the same period, the CPI core rate has risen 2.1 percent.

``The tremendous rise in all these costs has been steep enough and has gone on long enough that it's putting an awful lot of pressure on business costs,'' says Roger Kubarych, a former Fed staff economist who is now a senior economic adviser at HVB America Inc. in New York.

Policy Makers' Concerns

Fed policy makers themselves have expressed concern. At their Aug. 9 meeting, they said ``energy price increases probably would feed through, at least temporarily, to core measures of inflation,'' according to minutes of the Federal Open Market Committee. Inflation as measured by a favorite Fed index, the personal consumption expenditures core rate, is near the top of the 2 percent range policy makers consider acceptable.

While inflation concerns aren't limited to the U.S., that's where the risk is greatest, according to a new index created by ABN Amro Holding NV, the biggest Dutch bank. The measure, designed by London economists for the Amsterdam bank, compares inflation expectations in 15 countries and gauges factors such as labor- market tightness and the ability of companies to pass on cost increases.

Crude-oil prices are up more than 40 percent since May. Gasoline prices have more than doubled since December 2001. Natural-gas prices have more than doubled since May. Ocean freight charges are more than 72 percent since early August. Utility rates have risen by 13 percent in 11 months.

Just-in-Time Inventories

HVB's Kubarych says energy costs may get passed through faster today than a decade or two ago because transportation is so crucial to the just-in-time inventory practices adopted during the 1980s and 1990s. Transportation costs rose at a 15.6 percent annual rate during the three-month period that ended in August.

Some companies already are passing on higher energy costs on to customers. Miami-based Carnival Corp. the world's largest cruise operator, raised prices by as much as 16 percent. Memphis, Tennessee-based FedEx Corp., the No. 2 U.S. package shipping company, added a surcharge to trucking charges to recover rising diesel fuel costs. Bethesda, Maryland-based hotel operator Host Marriott Corp. raised room rates in cities including Washington and New York.

Higher-priced petroleum has forced price increases by makers of chemicals and plastics used to make goods from auto parts to beverage containers. Kingsport, Tennessee-based Eastman Chemical Co., the biggest maker of plastic for soft-drink bottles, raised prices as much as 40 percent for bottle-grade resin. New York- based Pepsi Bottling Group Inc., the world's No. 2 soft-drink bottler, in turn raised its prices because of increased costs for packaging and fuel.

Accepting Increases

Customers accept higher prices because they realize costs have gone up, says Peter McCausland, chief executive Radnor, Pennsylvania-based Airgas Inc., the largest U.S. distributor of industrial and medical gases.

``Our customers understand that 60 percent of the cost to produce our products is electricity,'' he says. ``We spend a lot on fuel to get the products to the customers. So customers are more receptive to pricing.''

Other companies raising prices for materials used in making finished goods include Midland, Michigan-based Dow Chemical Co., the biggest U.S. chemical company; Wilmington, Delaware-based DuPont Co., the No. 3 U.S. chemical maker; and Philadelphia-based Rohm & Haas Co., the world's biggest producer of acrylics used in paints and plastics.

Higher Prices

``Ultimately, it will be higher prices for the consumer,'' says Charles Holliday, DuPont's chief executive.

Such increases have begun to alter inflationary expectations of consumers, too, according to the latest findings from a monthly University of Michigan survey. In September, the poll showed consumers expected inflation to rise to 4.3 percent by September 2006 -- the highest expected since 1990. That compares with a 3.1 percent year-ahead forecast in August.

Inflationary expectations, in turn, could influence wage demands, Kubarych says. For the past year, wage increases have been running at about 2.6 percent, barely enough to keep pace with inflation. Workers who fear accelerating inflation will demand bigger raises, Kubarych says; once increases get built into the wage-price cycle, inflation becomes more difficult to tame.

Increased Leverage

A strengthening labor market is giving workers increased leverage. Last week, Chicago-based Boeing Co., the world's largest aircraft maker, reached a tentative agreement with striking machinists after boosting pension payments and dropping a requirement that workers pay more for medical insurance. The settlement, after a 24-day strike, was the quickest between the company and its largest union in four decades.

Not everyone is convinced the gain in energy prices is about to turn into a broader inflation problem. Janet Yellen, president of the Federal Reserve Bank of San Francisco, told a London conference last week that price indexes were ``well behaved'' for the six months before Hurricane Katrina, while wage increases were ``remarkably subdued.''

While core inflation may rise temporarily, ``a more persistent increase in inflation, such as was witnessed during the 1970s, seems unlikely as long as inflation expectations remain well-contained,'' Yellen said.

International Concerns

Concern about the possibility that inflation may accelerate isn't confined to the U.S. The Washington-based International Monetary Fund on Sept. 21 forecast inflation in advanced economies will reach 2.2 percent this year, the highest since 2000.

Inflation in the 12 nations that share the euro accelerated last month to the fastest pace since May 2004. In the U.K., inflation was 2.4 percent in August, the highest in at least eight years. Even in Japan, which has suffered from seven years of deflation, core consumer prices fell just 0.1 percent in August. That was the smallest drop since May, a sign that prices may soon rise in the world's second-largest economy.

European Central Bank council member Yves Mersch calls for ``particular vigilance,'' saying oil prices at current levels risk boosting wages and fueling inflation,

``The longer the oil prices remain high, the higher the risks,'' he said in an interview in Luxembourg last week.

To contact the reporter on this story:
Art Pine in Washington at [e-mail]


LINK: http://www.bloomberg.com/apps/news?pid=10000103&sid=aNQRxs8fhghw&refer=us