Inflation: When is a little too much?

06/12/2014 12:00 AM

06/13/2014 4:44 PM

All but absent in recent years, inflation is ticking up. That’s to the delight of those who think it signals a return to economic health, to the worry of others who think it’ll bring disruption to financial markets.

Headline inflation_ the rising prices consumers pay at the pump, grocery, restaurant or shopping mall_ increased 1.6 percent in April from a year earlier. It’s been driven up in part by a harsh winter and drought conditions in some regions, both affecting farmers and ranchers.

When volatile food and energy prices are stripped out of the calculation, so-called core inflation rose a more modest 1.4 percent over the same 12-month period.

It’s hardly the galloping 13.58 percent annual rate in 1980, or the punishing 14.65 percent in 1947 after the end of World War II. In fact it’s below the 2 percent inflation target that the Federal Reserve sees as the sweet spot that signals a healthy economy.

But April marked the first time consumer and wage inflation accelerated together since the Great Recession’s end in 2009, and it could mark a return to rising prices in an economy that faced the threat of the reverse. If sustained, it would mean workers have more power to demand higher wages in the face of rising prices.

Because inflation means a dollar buys less over time, it erodes purchasing power. That is why its return could change the calculation for borrowers seeking a loan, lenders debating whether to grant one, or investors choosing between stocks and bonds. And it could complicate payments on mounting U.S. debt since the United States conducts new borrowing to pay for past spending.

“All of this is modest, but clearly it’s the first time (in recent years) that we’ve had wages and consumer prices going up at the same time in an accelerated way,” said James Paulsen, an economist and chief investment strategist for Wells Capital Management.

Paulsen doesn’t forecast runaway prices or soaring wages. But because the economy has faced a bigger threat over the past five years from deflation, or the broad fall in prices and wages, returning to a period with inflation is likely to be unsettling.

“I do see the stars aligning for there to be greater inflation anxiety,” he said in an interview. “We’ve not had a serious inflation problem in more than 30 years. However, we’ve had multiple inflation panics over that period of time!”

The reason to keep an eye on this “inflation anxiety” is that inflation, or perceptions that it is coming, could lead investors to demand higher returns in return for holding government or private bonds. Bonds have a maturity period, ranging from months or years to the so-called long bond which matures in 30 years. Since inflation erodes the value of the investor, bondholders demand a better return as an offset. The higher the return, the more attractive it is as an investment compared to riskier stocks, whose price is more volatile.

The same dilemma holds for banks when they lend money for the purchase of a home, car or other big-ticket purchase. The money they earn in interest will buy less down the road because of inflation, and they must price into the loan their inflation expectations. Home buyers, similarly, must weigh whether their home-price appreciation will be great enough over time to offset the increased interest expenses.

The Federal Reserve uses its benchmark interest rate to try to tamp down an economy that is getting too hot, knocking back inflation. But since December 2008, the Fed has kept this rate as low at is can possibly go, near zero, in order to spark borrowing and consumption in the sluggish economy and odd as it may seems, spark some inflation.

As the economy improves, the Fed has slowly been pulling back on stimulus, slowing its purchases of bonds that have artificially held down long-term lending rates. It’s one more reason why economists are watching for signs of inflation.

The U.S. economy right now does not seem anywhere near overheating. But there are some signs just under the surface that growth is picking up steam.

“The sand under your feet moves often before you realize how much it’s moved,” cautioned Paulsen, pointing to an unemployment rate of 6.3 percent and heading lower, factory utilization rates that are climbing, strong car sales and an increase in credit extended to consumers.

Other economists see no reason for concern about inflation right now.

“Wage inflation is showing up everywhere but in the data,” insists economist Alan Tonelson in his RealityChek blog. “Moreover, whatever wage pressures are being felt in individual parts of the economy are much weaker than widely reported price increases in food, higher education, housing … and other sectors.”

Tonelson doesn’t dispute the 2 percent-plus growth in wages for non-supervisory workers cited by Paulsen, but points to 2007, the last year before the Great Recession unfolded. Wages for these workers back then were rising at a 4 percent pace from January through May.

“That’s more than twice as fast as this year,” he said, adding that it reflected an economy with growth that proved unsustainable and “no one claims that overall inflation was raging out of control” then.

Some economists think a little more inflation might be welcome.

“It’s not like the second we see wage growth, do we really want to slam on the brakes?” said Heidi Shierholz, a labor economist with the Economic Policy Institute, a liberal think tank.

Rising wages and prices would signal an economy growing healthier, she noted, adding that “if we’re actually seeing it, it would actually be a positive development for the economy, not just for the families involved.”

A spark in inflation that triggers bigger moves in interest rates, however, would be bad news for U.S. debt, now standing above $17 trillion. Just a 1 percent increase in the cost of new borrowing to pay what’s already racked up would amount to another $170 billion annually, said Kent Conrad, a former North Dakota Democratic senator who headed the powerful budget committee.

“Anybody who knows the structure of the federal debt cannot but be concerned about interest rates,” Conrad said, calling rising debt-servicing costs “a mathematical certainty.”

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