Inflation Warning: Should the Fed Raise Interest Rates?

By PETER COHAN

It's no surprise that prices are rising -- the question is whether the Fed will do something about it. As I pointed out in a Daily Finance article in October, prices of commodities -- including corn, wheat, and cotton -- have recently hit record levels. Demand from emerging markets is strong and increasing as China's 10% annual growth brings more of its 1.3 billion people from the countryside to the cities. And after a bad harvest, the volume of cotton to meet that demand is weak.

Now clothing prices are expected to rise in the U.S. by 10% thanks to those record cotton prices. Winter gasoline prices are higher than they've been in years, and they could rise as the summer driving season approaches. China has started hiking interest rates and forcing banks to raise capital in an effort to rein in inflation there. But the U.S. inflation rate was a mere 0.5% in December according to the Bureau of Labor Statistics.

The Fed surely sees the inflation wave roaring across the Pacific to our shores. The question is whether it will keep interest rates low to boost job growth, or whether it will wait until workers demand and get higher wages that bake inflation into the expectations cake.

According to The New York Times , prices of cotton, leather, polyester, copper, iron ore, corn, sugar, wheat, beef, pork and coffee are at or near record highs and are likely to soar. But the prices of household goods represent a mere 25% of Americans' household spending, so the pain of price increases will be annoying but not catastrophic. And the U.S. is both a consumer and supplier of the commodities whose prices are spiking.

Feeling the Pain at the Margins
Many companies that sell in the U.S. market use those commodities in their products. The business challenge they face is whether to pass those higher costs along to consumers, or hold prices steady in order to hang onto their market share.

According to The New York Times , many consumer products suppliers are taking the first choice -- passing along their higher costs. Among the items you should expect to pay more for soon:

• Whirlpool ( WHR ) washing machines: up 8% to 10% starting Apr. 1;
• Hanes Brands ( HBI ) underwear up 30% by the summer; and
• Victoria's Secret ( LTD ) underwear up from $25 to $25.50.

Other companies are using a different technique to control costs -- giving consumers less for the same price. For example, restaurants are turning down their heat or air conditioning, and consumer product companies are taking such steps as putting fewer sheets in their rolls of toilet paper.

But companies are still scared of losing market share if they pass on the full weight of their cost increases, so their margins are likely to take a hit. According to The Wall Street Journal , Morgan Stanley ( MS ) estimates that about 25% of companies have reported lower margins in the latest quarter. And S&P notes that fourth quarter 2010 S&P 500 operating margins (8.69%) were lower than those in the third quarter (8.95%). Despite an expected 7.5% rise in 2011 revenues , about which I wrote on DailyFinance, those lower margins could crimp earnings growth.

Fear of Full Employment
The fundamental question is: What is inflation? More specifically, what kind of inflation will scare the Fed into action? The Fed tends to discount the significance of higher commodity prices because they are volatile, likely to go up and down erratically, and are thus not big contributors to long-term inflationary expectations. What the Fed does fear are rising wages, because wages are a big portion of corporate costs and when they rise, the higher costs get baked into companies' expenses through long-term contracts.

This puts the Fed in an awkward position. After all, Fed chair, Ben Bernanke, has been complaining about how it will take years for the job market to return to normal . But if the unemployment rate were to plunge to the 4% or 5% range, American workers would be in a stronger bargaining position to ask for higher pay.

And it's the threat of higher wages that really scares the Fed because when workers negotiate higher pay, companies have no choice but to pass those costs on to their customers. This leads me to consider an idea that might help out the U.S. economy : What if we created a futures market that employers could use to hedge wage increases like the markets for interest rate or commodity futures?

Until someone launches such a market, the statistic to watch closely as a harbinger of inflation is one of my personal favorites -- capacity utilization, the measure of how much slack the nation has in its factories. Capacity utilization is key because if it gets too high, companies will be pushing their workers beyond their limits, and they'll need to start paying people more to get them to work longer since there won't be as many extra people looking for jobs.

By that measure, the Fed is unlikely to raise interest rates any time soon: At 76% , capacity utilization in January 2011 was comfortably below the 1972-2009 average of 80.6%, according to the Federal Reserve. Of course, with inflation adjusted median family income down 8.1% between 2000 and 2009 , it's clear that companies have many tricks up their sleeves -- most notably outsourcing to lower-wage countries -- to keep high capacity utilization from forcing up U.S. wages.

So with inflation expected to be 1.3% for 2011 -- below the Fed's 2% target -- and workers still bent over the proverbial barrel, the Fed is likely to keep rates low even as higher commodity prices take a bigger bite out of Americans' declining incomes.

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