- The Washington Times - Thursday, May 18, 2006

One week after the Federal Reserve announced that the “extent and timing” of future increases in short-term interest rates would depend on “incoming information,” the Department of Labor issued a worrisome report on the behavior of consumer prices through the first four months of 2006. After increasing by 3.4 percent during 2005, consumer prices jumped at a seasonally adjusted annual rate of 5.1 percent during the January-April period. In other words, the rate of inflation, as measured by the consumer price index (CPI), has increased by 50 percent during the first four months of 2006 compared to all of last year. Meanwhile, energy prices at the consumer level, which increased by 17.1 percent last year, have risen at an annual rate of more than 30 percent during the first four months of this year.

The core CPI, which excludes the volatile food and energy sectors, increased by 2.2 percent for all of 2005. During the first four months of 2006, however, the core CPI has increased at a 3 percent annual rate. The significant acceleration in the rate of change of the core CPI confirms that there has been a big increase in the amount of energy-price inflation that has “passed through” to the non-energy sectors of the economy.

For more than two years now, as petroleum prices have steadily increased, the Fed has closely monitored the extent to which energy inflation has crept into the prices of other consumer products. Until recently, energy-price inflation remained sufficiently contained. In both March and April, however, the core CPI increased by 0.3 percent, which happens to be the largest monthly increase during the past year. Annualizing a monthly change of 0.3 percent generates a 12-month rate of increase of 3.7 percent. This strongly suggests that there is now a danger of a major breakout in “pass through” inflation.

Should such a breakout come to pass, inflationary expectations and risk premiums would undoubtedly ratchet upward, commensurately lifting long-term interest rates, including the fixed rate for 30-year mortgages, the interest rate for 10-year Treasury notes and other debt instruments, such as corporate bonds. Under this scenario, a conceivable 2 percentage point increase in mortgage interest rates, which are now hovering at 6.5 percent, could send the housing market down. (The monthly payment for a 30-year $250,000 mortgage at 8.5 percent is $1,922, about $350 higher than the payment would be when the interest rate is 6.5 percent.) Also, with total federal debt likely to exceed $8.6 trillion by the end of fiscal 2006 (and projected to rise by more than $600 billion per year for the next three years), a sustained, across-the-board 2 percentage point increase in interest rates could, by the end of the decade, add $200 billion per year in interest expenses alone to federal-budget outlays.

So the stakes are high. With “incoming information” like the CPI report for April, the Fed should now be actively reconsidering the possibility of a pause in its tightening cycle.

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