Smith Faculty Opinion Article - October 18, 2005

Producer Price Report Shows Inflation Poses Little Threat
By Dr. Peter Morici, Professor of International Business

Today, the Labor Department reported the Producer Price Index rose 1.9 percent in September, thanks largely to a surge in energy prices.

However, the report indicates inflation is not spreading to nonenergy goods and services that reach final consumers. The index for finished goods, less energy and food, rose only 0.2 percent, and prices for final consumer goods, less energy, were up 0.1 percent.

The latter two indexes are good predictors of future consumer price inflation. For example those were down in August, and the CPI, less food and energy, rose only 0.1 percent in September, reflecting some retail markup.

Consumer price inflation will likely be tame in the months ahead. Gasoline prices and crude oil have fallen in October. The recent spurt in energy prices has not passed through to wages, which account for about two thirds of production costs, and rapid productivity improvements are permitting businesses to absorb rising energy and material costs before those reach final consumers of nonenergy goods.

The core CPI, the CPI net of energy and food, has risen only 0.1 percent or less each month for the last six months, and todays report on wholesale prices indicates future inflation likely will be contained.

The modest increase in wholesale prices for final consumer goods less energy indicate Federal Reserve concerns about inflation are exaggerated. Coupled with slowing automobile and other retail sales, this cooling of core inflation indicates consumers are strapped, and additional interest rate increases are not needed.

The reason for near zero inflation outside the energy sector is quite simple. Consumers have no more money to spend. Consumption exceeded disposable income in June, July and August. Credit card delinquency rates are very high.

Consumers can no longer easily add to credit card debt and home equity loans. With gasoline prices up, they are cutting back on spending in other areas. Stores like Wal-Mart are already discounting to accommodate weak consumer spending, which is resulting in lower prices for most products.

Some retailers and auto manufacturers are attempting to raise prices in October but those efforts will be frustrated. Attempts to raise prices will be met with fierce consumer resistance.

Energy prices will subside as Gulf oil, gas and refining come back on line. When energy prices fall, deflation, not inflation, may be the problem. Should the Fed persist in pushing up interest rates, it risks throwing the economy into a recession.

The Fed has no need to tighten credit markets further to slow the economy.

Higher energy prices have done the work of higher interest rates, and the Fed should not raise interest rates in December.