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Thursday March 24, 2005 - 14:47:09 GMT

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Has the Fed left it too late?

There will be further US inflation concerns in the short term after the higher than expected inflation data this week, although in historic terms the pressures are still relatively mild. The Fed is probably regretting waiting so long before increasing interest rates last year, but a sudden and panicked more to accelerate monetary tightening now would be counter-productive. A gradual increase in interest rates will still be in the best interests of the US and global economy.
Weaker growth data would increase speculation over stagflation and this would be a greater threat to the economy. If there is greater evidence of stagflation over the next few months, confidence in US bonds, equities and the dollar could be seriously damaged. There is also likely to be a robust debate on the merits of inflation targeting.

Inflation moves higher

US inflation concerns have been a significant focus over the past week, particularly with the release of monthly price data and the meeting of the Federal Reserve interest rate setting committee.

The inflation figures caused concerns with headline consumer prices rising 0.4% in February, the largest monthly increase for September. The annual rate increased to 3.0% and, although this was still lower than the 3.5% seen in November 2004, the underlying annual rate was running at the highest rate since May 2002. Within the inflation figures, there were significant monthly increases for transport, housing and medical costs. The rise in transport costs will be due in part to rising oil prices and energy costs are an important factor behind the inflation rise. There will, however, also be greater concerns over a more general rise in services-sector inflationary pressure.

Producer prices rose 0.4% in February, pushing the annual increase to 4.7%. The underlying increase at 2.8% was the biggest increase since November 1995. The rise in inflation will invite speculation that the Fed kept monetary policy loose for too long and will create fears that the central bank will now find it very difficult to contain inflationary pressure without a more aggressive monetary tightening.

Risk of imported inflation

There will be further concerns over imported inflation pressure with import prices rising by a further 0.8% for February. Oil prices have eased over the past few days, helped by a dollar rebound, but prices are still close to US$55 p/b. The rise in energy costs will inevitably have an impact on inflation and sustained increases in energy prices would increase the risk of wider inflationary pressure as it becomes more difficult to avoid passing on cost increases.

The persistent dollar weakness over the past two years will also pose inflation risks, although the US is less vulnerable than other economies in this respect. The traded-goods sector is a smaller proportion of the economy and many commodity prices are also priced in dollars which lessens the potential inflationary impact on the US economy.

Fed will need to be on alert

The Federal Reserve is wary over rising inflationary pressure and is also concerned that companies have a greater ability to pass on cost increases. There is, however, still very tough competition in the traded-goods sector which will limit inflation concerns. The Fed will consider a faster pace of monetary tightening, but great care will be needed, particularly as the Fed needs to retain domestic and overseas confidence in US monetary policy. A more aggressive tightening could be seen as a tacit admission that the Fed had got policy wrong and this could act to destabilise market confidence in Fed policy, especially if bond yields rose sharply. The Fed will also need to maintain as smooth a policy as possible to bring about a controlled adjustment of US imbalances.

Money supply under control

The latest money supply figures do not suggest excess liquidity. Narrow M1 money supply increased only 3.9% in the year to February while there was a 5.5% increase in broad money supply growth. Money supply growth at this level does not suggest excess liquidity creation.

Concern over asset prices

There will be concern over the risk of inflation in the housing sector, especially as prices have increased rapidly over the past two years. Property inflation is, however, due primarily to low long-term rates, partly as a result of Asian bond buying. There are uncertain linkages between housing-sector inflation and more general price inflation. Nevertheless, the housing inflation does suggest that liquidity has been too loose over the past two years. Rising bond yields will be an important element in helping to curb domestic inflationary pressure.

Stagflation a threat

A more worrying interpretation for the US economy is that inflationary pressure will rise at the same time as growth in the economy slows. Such a development could put the Fed in an extremely difficult position from mid year. The need to increase interest rats to combat inflation would be in direct opposition to the pressures for low interest rates to sustain growth and maintain full employment. The risks for the US will be increased by the fact that there is very little room for manoeuvre on fiscal policy.
A trend towards rising inflation would also ensure a very tough debate on the subject of inflation targeting for the US Fed. Stagflation would also severely erode confidence in US assets and the dollar.


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