Inflation Issues

Inflation indicators have been volatile this year, reflecting
wide swings in the price of crude oil and gasoline. Both oil
and gasoline have been ticking up recently, partly for
seasonal reasons and partly in view of speculation concerning
hurricane activity.

Strong upswings in both gasoline and oil from 01/07 well into
the spring pushed up the inflation rate sharply. Real wages
declined over the first half of the year as a result, and this
development has undercut the near term economic outlook. That
fast surge of inflation no doubt influenced the Federal Reserve
to maintain inflation pressure as its primary target
through July. The Fed is concerned not only that inflation
will raise the cost of capital, but that real household income
can be threatened as well, since wage rates change far more
slowly than does inflation that is heavily influenced by
volatile commodities prices.

Now as autumn approaches, oil and petrol prices are expected to
ease as driving conditions fall off the seasonal peaks in the
northern hemisphere. Shorter term inflation pressures may subside.
On balance, the longer term inflation indicator, although rising,
is still in benign territory.

Traditional bedrock indicators of monetary policy certainly do
not yet support a cut in the Fed Funds Rate, but if the Fed
remains concerned about financial market liquidity and its effect
on the economy, there is a "window" of seasonal weakness ahead
in key petroleum price composites that might offer "cover", as
headline inflation could remain modest. Naturally, the Fed also
knows that strong upward pressures on the petroleum complex
can develope over the first half of the new year reflecting
continuing demand for heating oil and the start of accelerated
gasoline production. the Fed must also contend with commodities
speculation, should the FOMC vote for rate cuts. The pit bulls
could well reason that monetary stimulus would eventually lead
to a stronger economy and higher demand for a variety of crude
materials.

There are a couple of other points worth remembering. Modest
inflation through year's end will lead to faster real household
income growth, providing the economy remains stable. Also, note
that the Fed has a little "breathing room" on the FFR at 5.25%.
With inflation running at 2.5% measured yr/yr, the Fed could
take the FFR% down to 4.75% and still leave savers with some
protection.