What if slow U.S. economy doesn't cure inflation?

By Emily Kaiser and Brad Dorfman - Analysis

WASHINGTON/CHICAGO (Reuters) - Package delivery company FedEx Corp says demand is sluggish, yet fuel prices are rising so fast that its surcharges can't keep up.

The owner of the Arby's fast-food chain says its price increases are not enough to compensate for rising costs of beef, labor and utilities. Meanwhile, fewer customers are coming in the door as the economy slows.

It is the worst of both worlds for the U.S. Federal Reserve, which is supposed to balance inflation and growth but seems to be losing ground on each front. Much of the blame has gone to the sagging U.S. dollar, which makes imported goods, notably oil, more expensive. And global demand remains strong.

The central bank says the U.S. economic slowdown will help keep a lid on inflation by curbing demand for labor and materials. Chicago Federal Reserve Bank President Charles Evans said on Monday that inflationary pressures would likely diminish because "the ability of businesses to pass along price increases is not as high" in a weak economy.

So far, the signs are pointing the other way. A Morgan Stanley survey of equity analysts found that 63 percent of the companies they track had raised prices this year.

"Investors hoping for the ideal scenario of a mild global slowdown, a stronger (U.S.) dollar, cooling inflation and lower interest rates abroad seem likely to be disappointed," said Richard Berner, Morgan Stanley's chief economist.

"The baseline I see will involve an unappetizing combination of slower growth, high inflation, and little decline in interest rates," Morgan Stanley's Berner said.

Indeed, even as the U.S. economy shows unmistakable signs of slowing, consumer prices are rising for a host of items including air fares, cigarettes, food, and medical care.

Part of the problem is that inflation pressure is not solely due to U.S. demand -- emerging economies are contributing too. A softening U.S. economy does little to curb China's appetite for oil, which briefly edged up to another all-time high above $126 per barrel on Monday.

SKIPPING VACATIONS

Overall U.S. inflation was up 4 percent year over year in March, according to the Labor Department's consumer price index. April figures are due on Wednesday, and are likely to show a continuation of that trend.

Stripping out volatile food and energy, as the Fed does when it looks to "core" prices to help guide its monetary policy, inflation was up a more modest 2.4 percent. Unfortunately, neither companies nor consumers have the luxury of ignoring food and energy.

Steven Wieting, economist at Citigroup in New York, notes that a 4 percent rate of inflation is nothing like the double-digit jumps seen at the peak of the 1970s era of stagflation, a period marked by both soaring inflation and a stagnant economy.

Inflation at 4 percent "is bad, but it's 1990 bad, not 1975 bad," he said.

Consumers are already feeling the pinch, though things would be even worse if companies were passing along all of the higher costs they pay.