Inflation Eases Off but Fed May Not

Prices Fell and Wages Rose in May; Experts See No Early End to Rate Hikes

Federal Reserve Chairman Alan Greenspan. (Dennis Cook - AP)

Consumer prices fell in May, the first decline in 10 months, as energy costs eased from highs hit in early April, the government reported yesterday.

The figures suggest that after a year of Federal Reserve interest rate increases, the U.S. economy is in pretty good shape, growing at a decent clip with low inflation, unemployment and interest rates.

But the Fed is far from declaring victory, or finishing its work of raising its benchmark short-term rate -- contrary to the hopes and predictions of many traders and analysts in the financial markets.

Federal Reserve Chairman Alan Greenspan indicated to Congress's Joint Economic Committee last week that the central bank remains concerned about the potential for future inflation. Interest rates remain too low. Labor costs are rising. Businesses are finding it easier to raise prices. And Fed officials are intensely studying whether the red-hot housing market might contribute to higher overall consumer prices.

To keep the lid on inflation, he suggested, the Fed probably will keep steadily raising short-term interest rates in the months to come.

Greenspan declined, as always, to indicate how high the benchmark rate might go before the Fed is through. But some analysts said yesterday that many investors are being over-optimistic in thinking the Fed may stop after raising the rate to 3.5 percent from its current 3 percent level. Instead, they predicted that the rate will be closer to 4 percent by the end of this year and approaching 5 percent by the end of next year.

The Fed might even raise the rate temporarily higher than necessary -- above a "neutral rate" that neither slows nor stimulates the economy -- to make absolutely sure inflationary embers are snuffed out.

The way Fed officials look at it, from a risk management perspective, it's better to overshoot a little when raising rates than to stop short, said William Dudley, chief economist at Goldman Sachs U.S. Economics Research.

"If you don't go far enough, you may have a bad inflation consequence; if you go too far, you can easily reverse," Dudley said, adding that stopping too soon would also damage the Fed's credibility in the markets.

Even so, recent tame inflation figures provide no reason for the Fed to raise rates more aggressively now, in either bigger or more frequent steps, analysts agreed.

The consumer price index, a widely followed inflation gauge, slid 0.1 percent last month after climbing 0.5 percent the month before, the Labor Department said. After excluding energy and food costs, underlying or "core" inflation edged up just 0.1 percent, after being flat in April.

That meant that average wages for most U.S. workers rose faster in May than consumer prices. But because energy prices had jumped so much in previous months, average weekly wages did not keep up with inflation over the year that ended in May.