Prices for lumber, steel, copper, and other industrial commodities soared, largely thanks to heavy demand out of China. Wall Street research reports highlighted the return of corporate pricing power in industry after industry. Scorn was directed at Federal Reserve Board Chairman Alan Greenspan for worrying about deflation. The Fed had fallen far behind the curve, said the critics, and interest rates were poised to skyrocket.
LOOSEN UP. That was then. Today, despite oil bouncing nearing $50 a barrel, the core inflation data (that is, minus the volatile energy and food components) is coming in at a remarkably tame pace. For instance, the core personal consumption expenditure deflator (PCE) rose by a mere 0.1% in July, following average monthly gains of nearly 0.2% since the beginning of the year. The core CPI also gained a mere 0.1% after months of 0.2% increases.
The producer price index? That inflation gauge has registered down in recent months. Bond yields have tumbled lower. Indeed, in a twist that has stunned the sagest of forecasters, bonds have substantially outperformed stocks so far this year, with the Lehman Brothers U.S. Treasury index hitting a total return of 2.2%, vs. a -4.2% return in the Standard & Poor's 500-stock index.
The bottom line: Inflation isn't coming back anytime soon. The Fed will probably hike its benchmark interest rate by a quarter point, to 1.75%, during its next monetary policymaking meeting in late September. But with the core PCE rate running at 1.5% year-over-year and the core CPI at 1.8% -- both well within the comfort zone of America's central bank and Wall Street before oil-induced visions of inflation past -- the time for the Fed to end its tightening cycle is near.
LITTLE UPWARD PRESSURE. The short-term outlook points toward easing price pressures. The demand for industrial commodities is cooling along with the Chinese economy. Manufacturing and service-sector capacity is ample, with economic growth slowing from the 5%-plus range to 3% or less. Job creation is weakening month by month, hardly an environment conducive to a wage-and-price escalation. Imagine walking into the boss's office and saying you'll quit if you don't get a 10% raise.
Other signs point to lower inflation rates ahead. Businesses are feeling little pressure to raise prices. The gap between the core CPI inflation rate and unit labor costs growth is quite wide, too, even though the latter has recently increased a little. This gap has historically given reasonably accurate signals about inflation's direction, according to Haseeb Ahmed of Economy.com, an economic consulting firm.
Profit margins are at a 47-year high of 8.5%, so employers can easily afford to pay their workers more and keep prices stable should business take a turn for the better.
STREET CRED. The easing of short-term inflation pressures is supported by long-term economic fundamentals. The global competition for jobs, markets, and profits is simply too intense. Take the accelerating trend toward outsourcing blue-collar and white-collar jobs to low-cost, high-skilled workers in developing nations like India, China, and Malaysia. Management also continues to burn the midnight oil devising ways to harness the productivity-enhancing promise of information technologies, which is one reason the job market remains weak.
The big risk in the economy isn't inflation, it's slow growth. The danger is that the Fed will slam the recovery by raising its benchmark interest rate too high, too fast. Yes, Greenspan & Co. have repeatedly pledged to hike the fed funds rate at a "measured" pace in coming months. Most Wall Street analysts predict that the benchmark rate will reach 2% before yearend and 3.5% in 2005. But the combination of 2004's oil shock and the Fed's tightening has dramatically slowed America's economic growth rate.
A deflationary and recessionary scenario certainly isn't what Greenspan intends. In light of the steep "oil tax," the current 1.5% fed funds rate is more restrictive than would have been the case earlier this year when the economy was expanding at a far more rapid pace. Investors widely anticipate that the Fed will hike its rate to 1.75% at the next Federal Open Market Committee Meeting in late September. If such a move would bolster the Fed's inflation-fighting credentials with Wall Street, then it should raise rates.
However, the Fed should then tap into its authority and declare victory in its recent skirmish against inflationary pressures. Tightening monetary policy when inflation is tame and the economy is decelerating is the wrong way to go. Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online