WASHINGTON -- The inflation numbers look terrific, so it must be time to raise interest rates again.

This perverse logic was at work again in the bond market yesterday after the Labor Department reported that the producer price index, which measures wholesale prices, fell 0.5% in October. The decline matched a 0.5% drop in September and marked a meager 1.0% rise in prices over the last year.

The last time there were back-to-back monthly declines in the PPI was in the summer of 1991, department officials said.

Moreover, by all accounts wage pressures remain subdued. According to a Labor Department report issued Wednesday, unit labor costs were up only 0.1% -- virtually unchanged -- in the third quarter. Such costs typically account for as much as two-thirds of a product's cost.

But analysts said despite the latest figures, the bond market is banking on Federal Reserve officials to respond to the strong economy by raising short-term interest rates to 5.25% from 4.75% when the Federal Open Market Committee meets next Tuesday.

In fact, the market is fully priced for another round of Fed credit-tightening. The Federal Home Loan Mortgage Corp. said yesterday that mortgage rates have reached the highest levels seen in over three years. In the week ending Nov. 11, the rate on 30-year mortgages hit 9.19%, and 15-year mortgages climbed to 8.67%. The rate on one-year adjustable-rate mortgages reached 6.01%.

"The Fed is looking ahead to 1995 and 1996. They know there are lags in the process, and they're trying to be preemptive and forward-looking," said Joshua Feinman, senior economist for Bankers Trust Co. "As long as the Fed sees the economy continuing to chug along at the pace we're seeing, they're just going to keep on raising the federal funds rate no matter how many good PPIs we get."

Analysts said that beneath the surface, there is some unsettling evidence that prices are continuing to bubble up toward the finished goods level. From there, it is one more step for them to show up in the broader consumer price index that is considered a better gauge of inflation.

In the last five months, the intermediate price index for wholesale goods was up at an annual rate of 5% to 5.5%, said Feinman. Excluding food and energy, intermediate prices rose at an even faster rate of 6.5% to 7%.

The decline in the overall finished goods index for October was also suspect because it was heavily influenced by a 2.6% decrease for new passenger cars. Auto dealers actually raised prices for the beginning of the new model year, but not as much as they have in the past. As a result, analysts said they believed the government's formula for seasonally adjusting prices was flawed and overstated what happened.

Moreover, other indicators that hint of rising price pressures are expected to be on the minds of Fed officials when they meet Tuesday. Commodity prices have been moving up, and the 5.8% unemployment rate reported for October is widely seen as signaling tighter labor markets.

In addition, the weak dollar has forced the Fed to intervene twice recently in foreign exchange markets. In time, a weak dollar adds to inflation by increasing the costs of imported goods. Analysts also note that factory operating rates are high, creating shortages in some industries.

"The Fed would rather err on the side of restraint," said Kevin Flanagan, an economist with Dean Witter Reynolds, Inc. "There are other forces out there that argue if the Fed doesn't do anything, it could become a potential problem down the road. You don't want a scenario of too little, too late."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.