Prices rise, and interest rates sure to follow

It could be a summer of rising interest rates.

That's the sobering prospect for the US economy following news that the inflation rate is running at a quickening pace. Higher prices for such things as airline tickets, housing, healthcare – and of course, gasoline – are now starting to eat into consumer pocketbooks.

Wednesday, the Labor Department reported the May Consumer Price Index (CPI) rose 0.4 percent, after a 0.6 percent rise in April. This is well above the comfort level of the Federal Reserve, the nation's chief inflation-fighter.

The latest numbers just about guarantee the Fed will hike interest rates at the end of the month. Its new chairman, Ben Bernanke, an avowed inflation-fighter, may follow that with yet another increase in August.

The inflation pop, however, comes at a time when the economy may be starting to cool. This could keep the Fed from hitting the brakes too hard.

"The Fed is going to have to raise rates more out of a desire to keep the market from thinking the new sheriff in town is not serious about fighting inflation," says Anthony Chan, chief economist at JP Morgan Private Client Services in Columbus, Ohio. "Prices are rising against a backdrop of weakening housing and other parts of the economy."

Economists are most concerned that rising prices seem to have moved beyond the energy sector. Removing food and energy – typically the most volatile prices – from the inflation rate indicates that "core" prices in May rose 0.3 percent. Over the past three months, the core rate of inflation is up to an annual rate of 3.8 percent, the fastest pace in more than a decade.

"We're seeing a near-term acceleration in the core rate," says Gregory Miller, chief economist at Suntrust Banks in Atlanta. "An increase of half a percentage point at the next Fed meeting is a strong possibility before the Fed decides to back away."

However, Mr. Chan reports that such a large rate hike is not likely. In the past, Mr. Bernanke has said previously, the Fed has tended to "overshoot" by raising rates too high or dropping them too low. The central bank would then have to change directions, confusing the markets.

"I don't think Bernanke is going to put in a strong case for a half a percentage point increase," Chan says.

Though the inflation rate is accelerating, the economy has changed considerably since the last major period of inflation in the 1970s, Chan says. Back then, whenever the consumer price index rose, wages automatically ticked up via "cost of living adjustments." Most of those arrangements are now gone, he says, particularly at manufacturing facilities, like General Motors Corp., where total remuneration is being cut, not raised.

"A slowing economy will eventually lead to diminished pricing pressures," Chan says.

Until that happens, consumers are starting to feel the effects of rising prices on their pocketbooks. For example, airfares rose 2.6 percent in May, according to the CPI report. Brian Hoyt, a spokesman for Orbitz.com, says airline ticket prices this summer are up 10 percent over last year's.

Amy Kelley of Calverton, N.Y., can attest to this. She's been searching for less expensive tickets for a vacation to Seattle. "I can't find the bargains I used to," she says.

While the higher airline prices are related to the rising cost of jet fuel, the CPI also points to rising medical expenses, which were up 0.3 percent in May.

In Philadelphia, Warren West, president of Greentree Brokerage Services, says the cost of providing medical benefits to his employees rose 16 percent this year. "There is no way to pass this on to the end user. We don't have that kind of pricing power," he says.

In fact, inflation in services is a growing issue, says economist Robert Brusca of Fact and Opinion Economics in New York.

"The last two months there has been service-sector wage pressure," Mr. Brusca says, pointing out that two-thirds of the jobs in the economy are service-related.

"Inflation pressure on goods is not that bad, but in services they seem to be building."

Part of the reason for the service-sector price increases is supply and demand, says Sandy Horwitz, an accountant in Coral Gables, Fla. His firm, Goldstein Schechter Price Lucas Horwitz & Co., has raised its billing rates 5 to 7 percent this year, he estimates.

"There is a shortage of accountants and pretty strong demand out there, so we need to meet people's salary requirements," he says.

Miami lawyer Matthew Krieger says demand for his legal specialty, immigration law, is so strong he has been able to increase his billing rates from 10 to 20 percent this year.

"There is a shortage of good attorneys in our area," he says. "It's a very complex area of the law."

In terms of prices, "rents" is one of the fastest ascending groups. The government calculates rents by determining what individuals would pay for housing if they were renting to themselves. Last month, rents rose 0.6 percent, the fastest pace in years. Since housing represents 25 percent of the CPI, it is a significant contributor to the overall inflation jump.

In Miami, landlord David Lombardy says tenants are now seeing rents climb – up about 30 percent in the past year, he estimates. A one-bedroom apartment at the Mirador on South Beach is now renting for $1,400 a month, up from $1,000 a month last year, he says.

Still, Mr. Lombardy expects rents to drop eventually due to the rising number of luxury condominiums coming on the market.

"All those people who bought on speculation will try to flip them, and when they can't do that they will try to rent them. So this will bring rents down in 12 to 18 months," he says.