The Producer Price Index (PPI) for May 2008 rose by 1.4% (an annualized 18.2%), which was above the 1.0% consensus forecast. Nevertheless, it is more than likely that inflation doves will largely ignore the headline figure and instead point to the 0.2% (2.4% annualized rate) increase in the core PPI (which excludes food and energy prices) to argue that inflation is not a gathering problem.

However, a closer look at the data suggests that the seemingly tranquil look on the core PPI front might not endure. Instead, a look at the intermediate and crude goods data shows a piling up of inflationary pressures--both headline and core.

In terms of intermediate goods, one has witnessed a quickening of the 12-month change in the headline price from 8.9% in January to 12.6% in May. Moreover, one has seen a steady rise in the monthly core rate for intermediate goods to 2.0% (26.8% annualized rate) in May. The last three months have seen the core intermediate goods index rise by 1% or more.

The same has held true with respect to crude goods. The 12 month change in the crude goods price has now come to stratospheric 41.5%. In addition, the core figure for crude goods has increased by more than 3% (42.6% annualized rate) for the last five months.



All said, there is building inflationary pressure in the pipeline. Recent data in the Fed's Beige Book suggested that some firms are successfully passing on higher costs to consumers and others are planning to attempt to do so. In short, inflation is leaking into the broader economy and there is a prospect that one could see the core rate begin to rise down the road.

In my view, a 25 bp increase in interest rates (not likely this month) this month could not be more timely and might be helpful in dampening growing inflation expectations. Unfortunately, I do not believe the Federal Reserve will make an interest rate move in its upcoming meeting later this month. Perhaps August 5 (after Q2 growth data is available) or October 29 (after Q3 figures are available) would offer additional logical points at which to raise rates.

Should the Fed fail to raise interest rates through the fall and should inflation not only continue to rise but also begin to manifest itself more strongly in the core price indices, already elevated inflationary expectations could become unanchored. If so, the nation's rising inflation problem could grow both in magnitude and persistence. Then the monetary policy prescription necessary to roll back the inflation could be much stronger than would otherwise be required and the economic price paid might well be a fairly significant recession as opposed to a milder economic slowdown or contraction.

Two reports released earlier today reaffirmed the ongoing trend toward higher inflation that is showing up in the recent Producer Price data.

• The Conference Board's data revealed that manufacturing labor costs per unit of output have been rising briskly since January. At the same time, the CPI for services has been rising at a slowly increasing rate.



• June 2008 data released by the Philadelphia Federal Reserve noted that a majority of Mid-Atlantic firms were paying higher prices for inputs. At the same time, a majority also planned to hike prices for their own finished goods over the next 3 months.

Select data follows:

- Reported higher input prices: 72% (vs. 61%) of firms surveyed
- The Philadelphia Fed's prices paid index jumped 16 points to 69.3. That is its highest reading since November 1980. It should be noted that the Consumer Price Index rose 12.6% in the November 1979-November 1980 timeframe. Therefore, the big increase in that index and its magnitude offer strong inflation signals.
- Expect to increase their own finished goods prices over the next 3 months: 65% of firms
- Average expected price increase: 5.4%
- Had already increased prices of their own finished goods since the beginning of the year: 70% of firms
- Average reported price increase: 3.8%

The Conference Board data offers an early hint that manufacturing wages could begin to add to inflationary pressures. The Philadelphia Federal Reserve data shows that a majority of Mid-Atlantic firms have already passed on some price hikes to consumers and that a majority is also planning to hike prices in the next 3 months.

Wage pressures will boost overall production costs. Right now, it is too soon to suggest the possible emergence of a wage-price spiral as occurred during the 1970s. But what is worrisome is that manufacturing wages began rising even as that sector was softening and shedding jobs.

The overall increase in production costs has two big implications:

1) It could ultimately push consumer price inflation higher, if companies are successful in passing on their costs to consumers. Increasing inflation could wipe out the impact of nominal increases in personal consumption expenditures. Real personal consumption expenditures account for just over 70% of the GDP. Hence, should real personal consumption expenditures grow negative on account of rising inflation, the real economic growth could further slow and the development of a period of economic contraction would become more likely.

In turn success in passing on those costs could further elevate inflation expectations. Per the University of Michigan's household survey and the Cleveland Federal Reserve's adjusted TIPS data, 10-year inflation expectations have increased about 70 basis points since the beginning of this year. Should the trend of rising inflation persist, headline inflation continue to exceed the market consensus, core inflation begin to deteriorate, and the Federal Reserve fail to act to quash inflation, the risk that inflation expectations would become unanchored could increase dramatically.

2) Should firms find it difficult to pass on costs to consumers, profit margins could begin to shrink and additional firms could see their profits disappear entirely. Such a development could lead to a broadening of the economic weakness now plaguing the construction and financial services sectors, as well as non-export-related manufacturing firms. At the same time, it could shift investor expectations toward lower profit growth and that development could further worsen overall market psychology. Any unanchoring of inflation expectations would tend to amplify the negative sentiment. The risk of a fairly significant (5%-10% or greater) downturn in the stock market from present levels could grow. Such a decline in equities prices could have a reverse "wealth effect" leading consumers to spend less. In turn, such reduced spending would slow economic growth or increase prospects of a recession.

Should attempts at pass-through fail, firms could also embark on new cost-cutting efforts. Then, the rate of job losses could accelerate. Increased job losses would also have a negative economic impact.

In sum, inflation, along with energy prices, likely remains among the biggest economic risks going forward. The Fed's current choice may well be somewhat higher interest rates along with even more sluggish economic growth now or notably higher interest rates and a much more significant economic downturn later should inflation accelerate and inflation expectations become unanchored.

Finally, should the Fed's present accommodative monetary policy (under which inflation-adjusted interest rates up to a 10-year maturity are negative) mark a regime of increased tolerance for inflation, that development could amount to very bad news for investors and pension funds. Longer-term persistence of elevated inflation has been unfavorable for stock prices. For example, during the inflationary 1973-81 period, the S&P 500 Index rose 20.0% from 102.09 to 122.55. However, consumer prices more than doubled during that period. As a result, the after-inflation return on the S&P 500 Index was -54.3%.