WASHINGTON - The job of the Federal Reserve and government policymakers got considerably more complicated yesterday when the Labor Department reported that consumer inflation is running at an annual rate of 5.6 percent, its highest level in 17 years.
The Federal Reserve has been worried about inflation, or the rise in prices across the economy, for months. But it has left its benchmark federal funds rate at 2.0 percent since April, betting that the inflation pressures will ease when energy prices fall back.
Oil prices are off more than $30 from their peak of $147, yet the Bureau of Labor Statistics said yesterday that consumer prices soared 0.8 percent in July, twice the rate that mainstream economists had expected.
Even the core inflation rate, which excludes volatile food and energy prices, exceeded expectations by jumping 0.3 percent to a 12-month rate of 2.5 percent.
Yesterday's numbers deepen the Fed's dilemma. If it raises interest rates to quell inflation, it risks tipping the fragile economy into recession. If it allows inflation to gather steam, it loses its credibility as the firewall that protects consumers and businesses from the corrosive effects of inflation.
"The Fed is in the same uncomfortable position as it has been for months - caught between a weak economy and elevated inflationary pressures - only more so," said Kenneth Beauchemin, an economist with forecaster Global Insight in Lexington, Mass.
In a research note for investors, he added, "We continue to expect the Fed to hold the fed funds rate at 2.0 percent into 2009."
That means that rates would remain the same in the Fed's September, October and December rate-setting meetings.
What's unusual about this economic downturn is that the federal funds rate, which influences the prime rate and a host of other lending rates for consumers and businesses, is low by historical standards but isn't having the positive effect that it typically has.
That's because the steep crisis in the housing sector spilled over into the financial sector, and banks have sharply tightened their lending to consumers for homes, cars and even college tuition. This amounts to a credit crunch.
"The problem is the fear in the credit market, and it is going to take a while to settle down. I think it is two years, and we're only halfway there," David Wyss, chief economist for Standard & Poor's in New York, said in an interview.
Meanwhile, prices for consumers keep surging, pushed up by this year's run-up in the prices of oil, natural gas and a wide range of other commodities. These high costs are feeding into the prices that consumers pay at the cash register, and yesterday's soaring numbers reflect the third consecutive month of super-sized inflation. Inflation in June jumped 1.1 percent, on top of May's 0.6 percent increase.
For consumers, an annualized inflation rate of 5.6 percent means that they'd need to see their wages increase by that amount just to break even with rising prices.
"Gasoline prices rose 4.1 percent [in July] and are up 37.9 percent in the past 12 months. Food and beverage prices are up 5.8 percent in the past 12 months," Gary Bigg, a New York economist with Bank of America, wrote in a research note.
The broad index of consumer goods was driven up partly by the unabated rise in food prices.
"Food prices continued to pressure the top line, rising 0.9 percent following a 0.8 percent June advance. Five of the six major grocery-store groups posted increases of at least 1.0 percent; restaurant meal prices accelerated in July," Beauchemin, the Global Insight economist, said in a note to investors.
July's 0.8 percent jump came even as oil prices began falling back. But if oil continues its slide it could ease inflationary pressures late in the year and lessen the Fed's dilemma.
"The good side is we know oil prices have come down since July, and that should make it a little easier for them," Wyss said. "They're in a box, but that box isn't that uncomfortable and it's pretty well-padded."
So when do things get better?
One key factor will be when the housing slide hits bottom. Home prices are in retreat in much of the country, and the National Association of Realtors reported some positive signals yesterday, although they were far from bringing cheer.
Existing-home sales rose from May to June in 13 states, but it was thanks to steeply discounted home prices, the trade group said in its quarterly survey. Almost a quarter of metro areas showed rising home prices in the second quarter of the year compared with a year ago. Thirty-five out of 150 metropolitan areas surveyed showed gains over the second quarter last year, while 115 saw price declines.
"In many areas with large concentrations of foreclosure sales, homes are being purchased below replacement costs," Richard Gaylor, president of the Realtors association, said in a statement. "Many buyers with long-term expectations are getting exceptional value in the current market."
Sellers, however, are being forced to sell below cost.
The Realtors survey found that median prices for single-family homes fell 9.6 percent for the second quarter. They fell 0.9 percent in the Midwest, 4.1 percent in the South and a whopping 17.4 percent in the West.