Inflation doesn't slosh out of oil patch


If recent trips to your local gas station leave you feeling as if a second mortgage might be more useful than a credit card, it's no surprise.

After all, gasoline prices nearly doubled in the past 19 months as crude oil prices tripled - meaning that when payment time rolls around each month, it takes more than a glance to tell which bill is from Exxon and which is from Hecht's.

And yet, while higher prices for gasoline, heating oil and natural gas are putting an extra pinch on consumers' pocketbooks, research conducted by Merrill Lynch & Co. finds that rising energy prices won't touch off an inflation conflagration that sweeps through the economy.

"When oil prices began moving up, we looked at what kind of effect increased oil prices have on inflation," says Gerald D. Cohen, a senior economist with Merrill Lynch.

"What we found is that there is no 'pass-through' of these higher energy prices into the 'core' - or nonenergy - portion of the economy."

That's important to understand at this juncture, when inflation fears and the possibility of additional interest-rate increases by the Federal Reserve hang over the stock-and-bond markets - not to mention consumers - like a gloomy, gray sky. The central bank's policy-making arm, which already has boosted rates six times since late June 1999, meets again Aug. 22, and some economists worry that additional rate increases could choke off the U.S. economy's record run of prosperity.

Even so, the idea that rising energy prices aren't rampantly inflationary seems counterintuitive - until you consider it carefully.

Crude oil prices rose from about $10.70 a barrel in December 1998 to nearly $34.70 at the end of June. Gasoline prices rose significantly, too, achieving a record average of $1.71 a gallon last month. Other fuels also have soared in price: Natural gas jumped just under 8 percent in June, the largest one-month increase on record.

Mostly because of these big increases in energy costs, the Consumer Price Index for June rose at a pace that, if annualized, would put the overall inflation rate at more than 7 percent - well into danger territory as defined by the inflation-hawk Fed.

With volatile food and energy prices factored out, however, the CPI rose only 0.2 percent - or a palatable 2.4 percent annualized. It's this so-called "core" rate of the index on which economists and the Fed tend to focus - which also explains why rising energy prices have less of an inflationary impact than one might predict.

First, energy prices are not as influential as you'd expect, accounting for only 7 percent of the CPI: The motor fuel that powers your car or SUV is 3.2 percent of the CPI, while the fuel that heats your house is 3.8 percent. So even if motor fuel doubles, it only increases your budget by slightly more than 3 percent - hardly a hardship.

Second, the U.S. economy has changed dramatically in the past few decades, Cohen says. Indeed, 55 percent of the CPI - a big chunk of the "core" rate of the index - is based on the prices consumers pay for such services as medical visits, an evening at the movies, or a cruise vacation.

Services weren't as important 20, 30 or 50 years ago, when the American economy was dominated by manufacturing, an energy-intensive enterprise, says Cohen. And the manufacturing we do today benefits from the improved management methods and efficiency-boosting technologies referred to in Fed-speak as "productivity enhancements."

The upshot: Energy costs aren't the influence they used to be, meaning the Fed can afford to look past the rise in gasoline prices in its ever-vigilant search for that economic cockroach - inflation.

"The [productive] output per barrel of oil has doubled in major industrial countries since the early 1970s, and the U.S. has led the way," says Cohen. "We're definitely able to produce more 'stuff' with less energy - and less labor - than ever before."

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