Burgeoning inflation poses question: How will Fed react?

NEW YORK — All that talk about the rebirth of the Goldilocks economy — not too hot, not too cold, just right — may not last long because there are signs the inflation bear is lurking right outside the door.

That’s not to say prices are going to suddenly surge and wreak havoc on the economy. But in parts of the economy, inflation is accelerating at the fastest clip seen in a long while. And that raises a big question: How will the Federal Reserve react?

Will this spur its policy-makers to become more aggressive in boosting interest rates? The answer will surely have a far-reaching effect for companies and consumers alike.

The economy seems to be in a good spot right now. Businesses have ramped up their spending again after a long pause, while consumers haven’t slowed their buying. The employment picture is improving, and productivity remains strong.

All that comes as the Fed raises borrowing costs to slow economic growth just enough to keep inflation in check. The Fed has raised short-term interest rates six times since June, and is expected to do the same again when its policy-makers meet on Tuesday.

But what happens after that is anyone’s guess, especially now there is some evidence that the days of tame inflation could be ending.

Behind this shift is the prolonged rise in crude oil prices, which have bested the $55 a barrel peak that they reached last October, as well as big gains in prices for other commodities such as gold, copper, coffee and cocoa. At the same time, the dollar has been slumping against most major currencies.

Those factors are boosting price pressures elsewhere. Just look at the surprising 0.8 percent jump in January’s core producer price index, which excluded energy and food and was largely driven up by higher wholesale prices in tobacco, cars, alcohol, clothing and toys. The gain was four times what analysts had expected and was the biggest one-month jump in the core rate since 1998.

Over the last year, producer prices are up 4.2 percent, according to the Labor Department.

Consumer prices, in the meantime, are also rising, yet at a slower pace. The core consumer price index is now at 2.3 percent on a year-over-year basis vs. the 1.1 percent it was at the same point of 2004.

Those gains are showing up in places like how much consumers pay for coffee. Kraft Foods Inc. said last week it has increased the price of its Maxwell House roast and ground coffee by 12 percent to cover rising raw material costs, which followed a similar move by Procter & Gamble Co. with its Folgers brand.

That isn’t to say that the Fed has ignored signs of building pricing pressures. According to the minutes from its Feb. 1-2 policy-making committee meeting, several officials suggest the possibility of an “upward skew” in inflation, especially if there were future declines in the dollar or productivity growth. And, the minutes said, some officials had already heard reports of firms having an “increased ability to pass cost increases through to product prices.”

The Fed’s quarterly survey of regional business conditions, known as the Beige Book, noted recently that companies hit with higher prices for fuel, steel and other raw materials were becoming more inclined to pass along some of those costs to customers. For instance, truckers in the Cleveland and Atlanta areas had indicated that they had been offsetting rising fuel costs with surcharges.

To date, the Fed has used what it calls a “measured” pace in raising interest rates to deal with this. In the six times it has boosted its target for the federal funds rate — the rates banks charge each other on overnight loans — it has raised rates by a quarter percentage point. The fed funds rate now stands at 2.50 percent.

There is some talk among economists, including Bear Stearns’ David Malpass, that the Fed might have to increase the size of rate increases to half a percentage point. He is forecasting the Fed funds rate will be at 4.5 percent by year end.

Merrill Lynch’s chief North American economist David Rosenberg points out that never in the past 30 years has the Fed failed to raise rates by a half percentage point at least once during a tightening cycle.

No wonder the bond and stock markets have been rattled. Inflation eats up the value of bond investments as investors demand higher yields to offset inflation’s effects. It also raises borrowing costs for companies and consumers.

The markets “may have incorporated some of this Goldilocks forecast of fast growth and low inflation,” Malpass said in a note to clients. “However, we don’t think the environment is ‘just right, not too hot and not too cold.’ Inflation and more rapid rate hikes will be a burden.”

Expectations have been for the Fed to keep boosting rates. Now the focus surely will shift on how high they will go.