Lower Inflation Sends Mixed Signals
Economists, infamous for their on-the-one-hand, on-the-other-hand predictions, were in full two-handed juggling mode today as the government reported that consumer prices fell sharply in September. But the consensus appeared to be that lower inflation was good news for consumers and businesses alike.
The Labor Department reported that the prices paid by the average consumer fell a half of a percentage point from August to September, the biggest one-month drop since November 2005. The main reason for the decline was a 7.2 percent drop in the price of energy. Overall, the cost of living is now 2.1 percent higher than it was a year ago. Consumers and investors celebrated their new purchasing power and pushed the Dow Jones industrial average above 12,000 for the first time.
On the other hand, however, some economists dourly pointed to worrisome signs buried in the statistics. So-called core inflation, which is the price of everything but food and energy, came in at an uncomfortably high 2.9 percent annual rate in September. Similar readings of core inflation in the past have caused the Federal Reserve to raise interest rates in the hopes of slowing the economy and tamping down inflation.
Carnegie Mellon University economist Bennett McCallum, a close watcher of the Fed, noted that the board prefers to gauge inflation by other statistics, such as those on personal expenditures published by the Commerce Department. Those numbers show core inflation rising at a troublingly high annual rate of 2.7 percent. "I am sure that they are not fully happy" with the latest numbers, McCallum says. "They want to move gingerly toward reducing inflation while hoping not to induce a recession."
But the Fed's gingerliness will most likely cause it to wait and see whether this month's energy deflation works its way through the rest of the economy and tamps down core inflation on its own, says University of Maryland economist Peter Morici, a former director of economics for the U.S. International Trade Commission. It typically takes at least three months for energy prices to be fully incorporated in the economy, he notes.
In addition, falling housing values will reduce consumers' spending power, which should slow the economy and further reduce inflationary pressures. So core prices should start falling soon and reduce the chances of a hike in interest rates, Morici predicts. Besides, he adds, the Fed knows that interest rate changes have even more of a lag. Interest rate increases often take as many as 18 months to have the full slowing effect the Fed hopes for, he says. "The Fed has to be patient," he says. "If it raises rates now, it won't do any good" immediately and might overly restrain the economy in 2007 or 2008.