ICS Magazine

Inflation Rises Above Fed Comfort Zone

May 26, 2006
Inflation Rises Above Fed Comfort Zone

WASHINGTON - Consumer spending grew in April at the fastest pace in three months but much of that spending went to pay for higher gasoline prices. Rising price pressures pushed a key gauge of inflation favored by the Federal Reserve up by the largest amount in 13 months.

The Commerce Department reported Friday that consumer spending jumped 0.6 percent last month, the biggest increase since a 0.8 percent rise in January. However, when inflation was removed, the increase in spending was a much smaller 0.1 percent.

"Consumers are becoming more cautious, having been body-slammed by the recent spike in gasoline prices, a cooler housing market and the cumulative impact of higher borrowing rates," said Brian Bethune, an economist at Global Insight, a private forecasting firm.

Rising energy prices were taking their toll on consumer confidence, which dropped to 79.1 in May, the lowest reading in seven months, according to the University of Michigan's survey of consumer sentiment.

Core inflation, excluding energy and food, was up 2.1 percent in April compared to the same month a year ago. This was the fastest increase in this inflation gauge since a similar 2.1 percent increase for the 12 months ending in March 2005 and was above the Fed's comfort zone for inflation.

The government reported that personal incomes rose by 0.5 percent in April, matching the March gain, with the strength coming from a big increase in wages and salaries.

The Fed conducts policy with a goal of keeping inflation excluding energy and food rising at an annual rate of 1 percent to 2 percent. While a 2.1 percent reading is only slightly above that target level, financial markets have grown concerned in recent weeks that the central bank may keep raising rates at coming meetings because inflationary pressures have begun to mount.

The concern is that big increases in oil prices this year could now be spilling over into other areas of the economy, upsetting the calm inflation environment that the Fed seeks to maintain as a way to spur economic growth.

To keep inflation under control, the Fed increases short-term interest rates to slow borrowing and economic activity. The Fed has boosted a key rate at 16 consecutive meetings over the past two years with the big question now being whether it will call a pause at its next meeting at the end of June or keep raising rates.

Some economists worry that the Fed could be caught in a bind with inflation rising but the economy already starting to slow. Too many rate increases in such an enviornment raise the risk of over-doing the credit tightening and possibly triggering a recession.

The 0.5 percent increase in incomes in April matched the gain in March and was propelled by a 0.9 percent rise in wages and salaries, the biggest such increase in a year.

The 0.6 percent increase in spending followed a 0.5 percent rise in March and was the strongest gain since a 0.8 percent jump in January.

However, much of that gain reflected the big jump in energy prices last month. Excluding the impact of inflation, consumer spending was up a much more modest 0.1 percent in April, matching the inflation adjusted rise in March.

The overall economy grew at a sizzling pace of 5.3 percent in the January-March quarter, the strongest rate in 2 1/2 years. But analysts are looking for that growth to slow to a more moderate 3 percent to 3.5 percent range in the current quarter, reflecting in part a slowdown in consumer spending.

Disposable incomes, the amount Americans have to spend after paying taxes, rose by 0.4 percent in April but actually fell by 0.1 percent after inflation was taken into account.

The personal savings rate, the amount of disposable income left after consumer spending is accounted for, remained in negative territory at minus 1.6 percent in April, down from a minus 1.4 percent in March. A negative savings rate means that Americans are not only spending all of their disposable income but dipping into savings and increasing borrowing.