Brooklyn's Progress
December 2005/January 2006

By Mitchell J. Held, Managing Director, Economic and Market Analysis, Citigroup

Sure, the headline numbers are worthy of worry.  In the year ending September, consumer prices are up 4.7% over the past year, producer prices are 6.9% higher and the “energy” component of the CPI is up 34.8%.  Yet in recent weeks, gasoline prices have retreated towards $2.00 per gallon and there have been cracks in the steady upward progression of natural gas and home heating oil prices, too.  And, so-called “core” rates of inflation seem tame. So, why all the worry and why all the rate increases with more supposedly coming down the pike?

Here’s the problem – changes in interest rates do not affect the economy today, they do so with a lag of six months or more.  So policymakers have to make decisions today based not on today’s economy but on the economy six or more months down the line.  They worry…

• What if energy prices rebound and how would such a move impact inflation expectations and economic behavior?
• The unemployment rate has slipped to just 5%.  Historically, a sustained move below 5% typically has been associated with accelerating wage gains.  Labor costs, a full two-thirds of total costs, are far more influential on inflation than are energy or other commodity costs.
• Productivity’s strength has helped keep labor costs low and profit margins healthy.  We’re well past the time of the cycle when productivity gains normally begin to wane.  Will costs play catch-up?  And if they do, will companies attempt to support margins with attempts to raise prices?

Tough questions, but questions that we think the Fed would prefer to answer with a bias towards higher rates.  Then, should it prove too much, the Fed could easily undo what they did.  Should the market believe that inflation was gaining the upper hand we’d have to expect much more of a rise in long-term rates, a steeper yield curve and a rising risk of recession.  The Fed doesn’t want to be in that position.  Our best guess is that the Fed stops raising the fed funds are in the area of 4½% early next year and that long rates (10-year UST) do not move much beyond a 4½%-5% range.

Mitchell J. Held is a managing director in the Economic and Market Analysis Department of Citigroup Global Markets.  Mr. Held, with more than 29 years of experience in the economics and investment field, focuses on delivering the economic message to Smith Barney’s Private Client Group. In addition to Smith Barney, Citigroup, a leading global financial services company, includes under its umbrella Citibank, CitiFinancial, Primerica and Banamex. Additional information may be found at http://www.citigroup.com/.