Smith Faculty Opinion Article	March 16, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

Consumer Prices Increase 0.4 Percent in February

Today, the Labor Department reported that the Consumer Price Index rose 0.4 percent in February, thanks in large measure to rising energy and food prices. The consensus forecast was 0.3 percent, and my published forecast was 0.4 percent.

Energy prices rose 0.9 percent in February, after falling 1.4 percent in January. Colder weather in February ran down inventories and pushed up fuel prices.

Food prices were up 0.8 percent, after rising 0.7 percent in January.

The core CPIconsumer prices less energy and foodrose 0.2 percent, after rising 0.3 percent in January.

Food and energy prices are quite erratic from month to month, and are much less affected by U.S. economic conditions and Federal Reserve interest rate policy than other segments of the economy. Consequently, Federal Reserve policymakers pay close attention to movements in the core index.

Since February 2006, core consumer prices have risen 2.7 percent, and the compound annual rate of change for the three months ending in February was
2.6 percent.

Core consumer price inflation remains above Ben Bernankes target range of one to two percent a year, and relief from this inflation is not likely before mid way through this year.

No Change Likely in Federal Reserve Interest Rate Policies

In February, gasoline prices rose 0.3 percent, as cold weather pushed up demand. U.S. refining capacity and stocks were already stretched thin by rising domestic demand and U.S. environmental policies, and pressures from export-driven growth and inefficient petroleum use in China made additional global supplies scarcer. Now, both U.S. fuel oil and gasoline stocks are well below 2006 levels, fuel prices are spiking sharply in March and the broader indexes of consumer price inflation in March and April will increase at rates Federal Reserve policymakers find quite troubling.

Inflation hawks within the Federal Reserves policymaking apparatus will be vocal but can offer Chairman Ben Bernanke few effective options other than to ride out the situation. U.S. environmentalists and Democrats in Congress will not abide new refining capacity, and it cannot be brought on line quickly. Only radical adjustments in Chinese exchange rate policies and export strategies, which Treasury Secretary Henry Paulson and President George Bush are unwilling to accomplish, could quell pressures on global and U.S. energy markets. By giving China a pass on its undervalued yuan and export subsidies, the Bush Administration has significantly limited Federal Reserve capacity to affect energy prices and control broader measures of inflation. This situation is likely to get worse.

For consumers, higher gasoline prices will begin biting significantly with credit card bills that arrive later in March, and this will moderate retail sales and consumer demand generally. Coupled with ongoing adjustments in housing prices and Chinese-inspired instability in equity markets, consumers will be cautious when shopping for nonessentials.

Consequently, pressure on core inflation, though significant and discomforting, will be less intense than on energy prices. Competition will limit price increases for apparel, automobiles, electronics, and other discretionary consumer items. For retailers, excess capacity will continue to squeeze margins, instigate productivity gains and minimize pass through of wholesale prices to final consumers for most non-energy and food items.

The combination of consumers less willing to spend and builders stuck with too many unsold new homes will severely challenge the economy to deliver the 2.3 percent first quarter growth Wall Street analysts are now predicting. Business investment and commercial construction will have to stage a rally, or economic growth will sputter along at 2 percent or less until inventories of unsold new homes decline to comfortable levels.

The Federal Reserve will not likely be able to accomplish both moderate inflation and reasonable GDP and employment growth. Faced with choosing between instigating a recession or an inflation spiral, the best policy course will be to do nothing.

These conditions will severely test Ben Bernankes judgment, patience and communications skills, and prove to be the crucible of his tenure. What he says will be as critical as his actions. He must calm financial markets and define for politicians the true impediments to price stability and robust growth if he is to succeed.

Sooner or later Ben Bernanke must focus the Congress and Administration on the inflationary pressures and constraints on growth imposed by U.S. energy policies and Chinese currency, trade and energy policies. If he fails to do that and inspire meaningful responses, the tradeoff between inflation and slower growth may become intolerable. Federal Reserve policy options will grow less pleasant.

Look for no change in Federal Reserve interest rate policy before August, slow GDP growth to continue until mid 2007, and some surge in inflation. In the second half, growth should improve, but inflation will remain a significant problem and largely driven by Chinas growth and appetite for oil. Too much growth in China would drive up oil and other commodity prices and instigate stagflation in the United States.

Outlook for Stock Prices

Moderate growth and stable interest rates will further strengthen corporate profits and investor confidence, though continuing concern about inflation makes a bull stampede unlikely. Corporate profits will outperform the U.S.
economy, as many large U.S. companies profit from growth in Asia. Those foreign profits will provide the legs under the large caps and support the broader market.

Prices for new and existing homes have moderated, not collapsed, and overall these have risen about 55 percent over the last five years. Recent adjustments in home prices should rein in speculation and cause major builders to rethink land acquisition strategies that contributed to housing inflation.

Ordinary investors should shift from buying bigger homes to buying more stocks. Also, concerns about the stability of Chinese and Asian stock markets should spark more interest in U.S. equities.

Overall, rising profits and stronger demand should push up stock prices.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.