Economic upturn spurs fears of future inflation troubles

WASHINGTON -- Department store shoppers are getting a bit of sticker shock along with their new spring and summer fashions. Clothing prices in February jumped by the biggest amount in a nearly a year.

Airline travelers have seen ticket prices rise for the past two months. Those still wary of flying are not faring any better at the gasoline pump, where prices so far in March are rising at the fastest pace in a year.

The speed and strength of the economy's rebound from recession has been a major surprise on the positive side in 2002.

New worries, however, are arising that the unexpectedly strong surge in activity could lead to inflation troubles down the road.

Clothes, airline tickets and gasoline are not the only items that cost more. Americans' bills for doctors, hospitals and drugs have climbed by 4.5 percent over the past 12 months, driving up payments both for individuals and their employers.

The struggling economy last year helped keep inflation in check and bargain-hunters happy because it was difficult for businesses to raise prices. But as the economy revives, things could turn around.

Surprise strength

"Just as the Fed was caught by surprise by the recession last year, they could be surprised this year by the strength of the economy and a jump in inflation," said Sung Won Sohn, chief economist at Wells Fargo in Minneapolis.

"We could get a triple whammy coming from stronger economic demand, higher energy prices and higher medical costs," Sohn said.

So far, Federal Reserve Chairman Alan Greenspan, the nation's chief inflation worrywart, seems unconcerned. He recently told Congress that he expected consumer prices, his favorite measure of inflation, to rise by a moderate 1.5 percent this year.

The most closely watched inflation gauge, the Consumer Price Index, has been well-behaved overall despite big jumps in some of its components. For the past 12 months, the index is up by just 1.1 percent, its best performance in 38 years.

Still, more than just a few economists have begun to focus on inflation threats.

Long-term bond prices, often a good proxy for market views on inflation, are on the rise, with 10-year Treasury bond rates close to 5.4 percent, compared with 4.8 percent a few weeks ago.

Those increases have pushed mortgage rates higher from their lows of last year. The benchmark 30-year conventional mortgage dipped to 6.47 percent in November, the lowest level in three decades. It hit 7.14 percent in the most recent survey by Freddie Mac, the mortgage company.

All of this comes even though the Fed has yet to start increasing the short-term interest rates that it controls. At its meeting Tuesday, the Fed left a key rate at a 40-year low of just 1.75 percent.

Rate increases coming

But in a message designed to address worries of financial markets, the Fed signaled that future rate increases were on the way. It changed the forward-looking portion of its public statement away from a yearlong tilt toward concerns about a sluggish economy.

Most economists believe that it will not be long, possibly at the next interest rates meeting in May, before the Fed moves rates higher.

Most analysts are forecasting a gradual rise through one-quarter percentage point moves in the federal funds rate. But others warn that a stronger economy will mean bigger and faster increases.

"Given recent events, the Fed may have to unwind last year's credit easing fairly quickly," said Mark Zandi, chief economist at Economy.com. "It is becoming increasingly clear that interest rates will be significantly higher by next year."

Zandi said the 1.75 percent federal funds rate could reach 5 percent by mid-2003.

That will mean higher payments to Americans on their bank savings accounts but added costs for millions of borrowers.

Commercial banks' prime lending rate, the benchmark for many short-term consumer and business loans, could hit 8 percent next year, well above its current 37-year low of 4.75 percent.

Some analysts even worry that the Fed, in its effort to battle the recession and the shock of the terrorist attacks last year, may have overdone the easing and might be unable to keep inflation from heating up even with an aggressive campaign to raise borrowing costs.

But David Wyss, chief economist at Standard & Poor's in New York, dismisses those worries. He says Greenspan has proved in his 14 years at the Fed that he can move quickly to stamp out inflation.

"There should be no worry that the inflation genie will get out of the bottle," he said. "The Fed still has plenty of time to do what it needs to do to keep inflation from getting out of hand."