Inflation down – but far from conquered

Last year, the nation's inflation rate declined to its lowest level since 2003. But now, economists are wondering if the 2.6 percent rate may be about as low as it's going to get for a while.

While this does not mean that inflation will become a dominant issue for the economy, it probably means that the Federal Reserve is going to continue to fret about it. And that may mean that instead of cutting rates this spring, the Fed sits tight until at least midyear.

"It's too early to declare victory on inflation," says Richard DeKaser, chief economist at National City Corporation in Cleveland. "Inflation may be down, but it's not out."

On the surface, the inflation numbers appear to be relatively benign. Thursday, the Labor Department reported that the December Consumer Price Index rose 0.5 percent, reflecting a hike in the price of gasoline. The so-called core rate of inflation, the inflation rate without food and energy, rose just 0.2 percent in December. However, economists are quick to point out that so far in the month of January, the price of energy is down substantially, reflecting the warm winter. "Most people have probably forgotten the rise in December already," says Mr. DeKaser.

What has economists worried are  signs that the economy is starting to recover some of its momentum. On Wednesday, for example, the government reported industrial production rose 0.4 percent, the first increase since August.

Even the housing sector is showing some signs of life, again reflecting the warmer winter. Thursday, the Commerce Department reported construction of new homes rose 4.5 percent in December.

"Even though construction was still weak, it was better on a seasonally adjusted basis," says Dan Meckstroth, chief economist at the Manufacturers Alliance/MAPI in Arlington, Va.

Mr. Meckstroth thinks the economy is now moving out of its slower pace. He says there are some signs business is getting rid of the high inventories, particularly in the auto sector.

One of the reasons for the improvement in auto sales – aside from the warmer weather that let people get to the showrooms – are lower prices. Last month auto prices fell for the fifth consecutive month. They were down 0.9 percent for the year.

If the economy is starting to firm up, the Federal Reserve's attitude toward inflation could start to change, says Robert Brusca, of Fact and Opinion Economics in New York.

While the economy was soft, the Fed could take a more relaxed posture, he says. But, now with capacity utilization rising, the unemployment rate low, and more tightness in the economy, he expects the Fed will start to change its approach.

"As the economy gets firmer, the Fed gets stricter about what it will let inflation do," says Mr. Brusca. "It's kind of like a teacher with the brighter students – there is a higher expectation."

One of the concerns is the possibility of a wage/price spiral. Economists say there is a six- to 12-month lag between low unemployment rates and rising labor costs. "The unemployment rate started 2006 at 4.7 percent and ended at 4.5 percent and we probably have not seen the full repercussions of that," says DeKaser.

1 | 2

Next