As Markets Seek Clues to Fed's View of Inflation, Deflator Index Cited

Bankers and investors wonder whether the Federal Reserve will raise interest rates this summer to head off inflation. But what is the inflation rate right now?

Fed Governor Lawrence Lindsey stirred some notice last week by saying he saw a "fairly high risk of inflation" and that the Fed wants to keep the inflation rate "a little under three" percent.

The Fed will meet to review monetary policy in early July and again in August.

Mr. Lindsey was referring to the Consumer Price Index, by far the best- known yardstick of inflation, which was at 2.9% for May. But another inflation measure, which the Fed also tracks, is sharply at odds with the CPI right now.

The deflator index, used mostly to calculate real growth of the economy, shows consumer price inflation at a 2% rate, nearly a full percentage point below the CPI.

That is an atypically wide gap between the two measures, according to Edward Yardeni, chief economist at Deutsche Morgan Grenfell/C.J. Lawrence. And the deflator, he said, is "probably closer to the actual trend of consumer prices than is the CPI."

The CPI charts the average change in prices for a fixed "market basket" of goods and services. The deflator is based on actual purchases.

Some differences are startling. The CPI registers medical care inflation at 3.7%, while the deflator puts it at a 1.9% annual rate.

Moreover, the CPI is seen by a number of economists - and most importantly by Fed Chairman Alan Greenspan - as upwardly biased on prices, perhaps by more than a full percentage point.

Some economists, including Roseanne M. Cahn of CS First Boston Corp. and Nicholas S. Perna of Fleet Financial Group, believe the CPI bias factor is probably closer to half a point, putting inflation during the past year at about 2.5%.

"The deflator is the prices of what we produce domestically, so it does not include such things as imported oil, which are reflected in the CPI," said Ms. Cahn. Energy prices have lately been a major inflationary factor.

"I still consider the CPI the single most important barometer of inflation," said Mr. Perna.

But the Fleet economist said he expects the Fed, which monitors labor markets for signs of inflation, to put significant weight at its August meeting on yet another inflation gauge, the employment cost index.

"It's the Rodney Dangerfield of indices," Mr. Perna said. "It gets very little respect because it appears quarterly and not monthly, but it does an excellent job of measuring costs in the labor market."

This summer, the little-known index could get its due from the Fed.

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