To other economic warnings, add inflation

If prices keep rising, it could sour consumers and make the recession fight more difficult.

From toys and airline tickets to food, gasoline, and jewelry, inflation is squeezing the American economy at a time when it's already struggling.

The main culprit is higher energy prices, since oil prices have remained above $90 a barrel for an extended period. But unlike past oil run-ups, business appears to be starting to pass on its cost increases to consumers. If that trend continues, it would have a wide impact, ranging from Federal Reserve policy to souring consumer sentiment.

"If we keep seeing inflation pressures similar to what we saw in November, there would be real problems out there," says Joel Naroff of Naroff Economic Advisors in Holland, Pa.

Consumer prices surged 0.8 percent last month, the highest rate of increase since November of 2005 in the wake of hurricane Katrina, the government reported Friday.

It's not surprising that consumers are feeling the heat: in November, producer prices rose 3.2 percent, the fastest rate since 1973, mainly because of energy price hikes. Even the core rate of inflation, the rate without food and energy, rose by 0.3 percent.

Former Fed Chairman Alan Greenspan says he's beginning to worry about the inflation numbers. "We are beginning to get not stagflation, but the early symptoms of it," he told ABC's "This Week" on Sunday. Staglation was a symptom of the US economy in the 1970s, when inflation rose despite low or no growth.

A significant part of the inflation rise was from an increase in apparel prices, up 0.8 percent from the prior month. Analysts struggled to explain the shift, some pointing to seasonal changes, others to the rising dollar.

"I don't know whether we're seeing business suddenly develop pricing power or they are just saying, 'I don't have a choice with all the other costs going up, I have to raise my prices,' " says Mr. Naroff.

He says the weak dollar may be giving business the cover to raise prices for items that are made in the US. Or they may be just passing on their higher costs of imports. "This is a warning sign," he says. "There is no question about that."

Consumers are keenly aware of the rising prices. In a survey of investors in November, the UBS/Gallup poll found that 74 percent say inflation is hurting the economy, up from 64 percent a year earlier. Over a third said inflation was "hurting a lot," the highest reading since the poll started asking this question three years ago.

"What is happening is that consumers are upset about prices," says Dennis Jacobe, chief economist for Gallup in Washington. Economists thought the surge in energy and food costs was contained, he says. But now, he wonders if the data indicates that business feels it has to adjust its pricing.

That's the case, for example, at Studio 24E, a boutique in Oakland, Md. Within the last two months, Greg Elliott, the owner, has had to start to raise prices by about 5 to 10 percent. "We tried to eat our increased costs, because what we do is customer service," says Mr. Elliott. "But now, even for jewelry that's getting repaired, that's very hard to do."

If you want to buy Hannah Montana bedsheets, backpacks, dolls, or handbags at Ty's Toy Box, they will cost about 25 percent more than they did a month ago. While part of the rise reflects a surge in demand for Disney's singing phenom, part of it stems from increasing cost pressures at Ty's, based in Erlanger, Ky. "Prices are up on our inbound shipping," says Ty Simpson, the CEO of the online retailer.

Mr. Simpson says he's actually losing money on some items because of increases in shipping costs. He says shippers have moved from charging by weight to charging by dimensional weight. So a large item like the Thomas the Tank Engine Track Rider, a toy train that children can ride, is now a money loser, despite a price tag of $249.99. The company has started charging more for the heavier items it ships.

In Elliott's case, it's not just increased shipping expenses. Gold is up about $200 a troy ounce so far this year. Stainless steel, popular with many consumers, has doubled in price. "We can only [absorb] so much of it; we've had to raise prices," he explains.

Almost anyone who shops for food can attest to higher prices somewhere on the shelves. For example, Mr. Jacobe says he enjoys munching shrimp. "Last year, a pound of shrimp cost me $8 to $9 but today, it's $14 to $15," he recounts. "I am just amazed how much food has gone up from seafood to milk to a loaf of bread."

The prospect of rising inflation in a slowing economy is not a welcome event for policymakers. The Federal Reserve is in the middle of lowering interest rates to try to keep the economy from slipping into a recession. At the same time, some members of the Federal Reserve's interest-rate-setting committee want to show that the bank is tough on rising prices.

"There is no fundamental reason for inflation to get in the Fed's way, but it will," says Lyle Gramley, a former Fed governor now at Stanford Policy Research in Washington. "There is a deep division in the Fed – the worst I have ever seen – among people who worry most about the credit problem and its effect on the economy and those who worry about inflation."

So far, Fed Chairman Ben Bernanke has set interest-rate policy by consensus. This is one reason for the Fed's very measured approach. Mr. Gramley believes he needs to ignore the inflation hawks, those worried about inflation flaring up. "He needs to borrow Alan Greenspan's shoes and put them on and read the riot act to these people," says Gramley, arguing for more interest-rate cuts.

Some economists are sanguine that the slowing economy will cool the inflation numbers. "We are expecting a much slower growth rate next year that will take a lot of pressure off the markets," says Ethan Harris, chief economist at Lehman Brothers in New York. "By the middle of next year, the inflation concerns will be gone."

The key to lower inflation will be stable or lower energy prices, he says. "If the US doesn't slow down, then that's a different picture.... But right now, we are predicting oil prices will be flat."

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