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.

And the rate may still get lower. Thursday, the government reported a large drop in new weekly unemployment claims. This followed a large drop the week before. Now, some economists are wondering if the January unemployment rate could drop to as low as 4.4 percent.

Even though inflation may not be showing up in the numbers, some business people say they can see it at work in more subtle ways. For example, Larry Roshfeld, a senior vice president at CorasWorks Corp. in Reston, Va., says inflation puts more pressure on managers, especially those in information technology, trying to meet profit projections. "Inflation puts pressure on the ability to grow profits," he says, "and one of the first places pressured is the IT department since there is no place to increase revenue."

Jay Whitehead, the publisher of CRO magazine, can attest to the squeeze taking place in the technology sector. His company planned a conference for corporate responsibility officers (CROs) in San Francisco but ended up moving it to Chicago. "Inflation is hitting the budgets in technology more than other sectors and everyone out West is crying the blues," he says. "Budgets were more open in the Midwest."

On an anecdotal basis, Mr. Roshfeld says companies are now more willing to allow employees to work from home in an effort to help cut commuting costs. "It used to be that only senior executives could work at home, but now that's spread to lower level employees."

Despite the slowdown in housing, some builders and developers say cost pressures are still a part of the business. Two years ago, new construction was running at about $100 per square foot, says Adam Cowgill, a real estate agent at Railey Realty in McHenry, Md.

Now, Mr. Cowgill says it's closer to $200 per square foot. And though some commodities, such as copper, have eased in price recently, he says drywall is up 15 percent over last year. "Once the price is up and everyone has become accustomed to it, no one wants to bring the price back down," he says.

Separately, Fed Chairman Ben Bernanke appeared before the Senate Budget Committee Thursday and warned about future implications of the rising costs of Social Security, Medicare, and other entitlement programs.

"If early and meaningful action is not taken, the US economy could be seriously weakened, with future generations bearing much of the cost," said Mr. Bernanke.

In early February, President Bush will present his 2008 budget to Congress. Although it's not clear if he will tackle the rising cost of entitlements, his new Treasury chief Henry Paulson has indicated this will be one of his priorities.

Bernanke's predecessor at the Fed, Alan Greenspan, was often critical of government spending as well. Bernanke will testify about the state of the economy in mid-February.

•Wire services were used in this story.