The big story in the markets this week is the continuing decline in commodity prices. Having flirted with $150 per barrel earlier this year, oil was trading on Wednesday at about $109. The Dow Jones/AIG Commodity Index is now down 0.6 percent for the year. Many are hoping that subsiding inflationary pressures will make consumers feel better and make it unlikely the Federal Reserve will boost interest rates. On Aug. 22, Federal Reserve Chairman Ben Bernanke  said that if slow growth and the declines in commodity prices persist, that should "lead inflation to moderate later this year and next year." (Alas, he noted, in true central banker style, that "the inflation outlook remains highly uncertain.") Accordingly, the markets for Federal Funds rate futures show that traders today believe there's a 94 percent chance the Federal Open Market Committee will keep rates steady at its September meeting (up from a 66 percent chance a month ago), and an 88 percent chance that it will do so at its late October meeting (up from a 46 percent chance a month ago).

Would that the reports of inflation's demise were true! Just as the Federal Reserve and many other observers were too slow to see inflation coming, they're too quick to predict its disappearance. Yes, the falling prices of commodities are welcome news. But on the way up, and on the way down, there is rarely a direct translation of changes in commodity prices into changes in consumer prices. In recent years—and especially in the past year—businesses have acted as shock absorbers, unwilling or unable for competitive reasons to pass along the full brunt of the costs. But many of the shock absorbers have become worn, suggesting that inflation is likely to rise even if commodity prices drop.

To get a sense of what I'm talking about, look at two measures of inflation: the Producer Price Index and the Consumer Price Index. The PPI measures the inflation that producers (people who buy stuff that they then package into other stuff or sell to other people) experience, and it breaks down the price increases in crude, intermediate, and finished goods. The CPI measures the inflation that consumers experience when they pay for gas at the pump, food at the grocery store, and clothes at the mall.

The PPI has been on a rampage in the past year, thanks to the raging costs of raw materials, commodities, and energy. In July, the PPI rose a hefty 1.2 percent from June, and the price for finished goods rose a worrisome 9.8 percent from July 2007. In the past year, the prices of crude and intermediate goods rose an incredible 51.2 percent and 16.6 percent, respectively. These numbers bear witness to a progressive absorption of costs as goods go through the supply chain.

A look at the CPI reveals another phase in inflation absorption. The CPI is running hot, too. In July, it rose 0.8 percent from June 2008, and 5.6 percent from July 2007—the highest level of this century. In the past three months, the CPI has been rising at a 10.6 percent annual rate. The data show a significant gap between the PPI (up 9.8 percent in the past year) and the CPI (up only 5.6 percent in the past year). Translated into English, it means producers have been able to pass on only about 60 percent of their higher costs to consumers. The result has been sharply lower profits. In the first 11 months of the current fiscal year, corporate income taxes are off 14.6 percent. Economist Paul Kasriel of Northern Trust  notes that operating profits over the S&P 500 have declined year over year for three straight quarters. Last week, with 96 percent of the constituents having reported, S&P 500 profits were down 29 percent from the year before.

But isn't that all in the past? After all, we know the Federal Reserve and the stock market are more concerned about the next three months than the last three months. And the recent fall in commodity prices should, in theory, translate into lower prices for all participants in the economy. Or maybe not. First, there's always a lag between the action in the commodity markets and the prices of finished goods—especially at a time when companies desperately need to pad their margins. Second, despite the action in the commodity pits in recent weeks, the indicators of inflation at the producer level have picked up pace through this year, accelerating through the second quarter and into July.

Third, many companies have reached their limit in absorbing higher costs. That is why we've had large bankruptcies in the restaurant industry (Bennigan's), and in retailing (Linens 'n Things). Today, every company is faced with a choice of absorbing the higher costs passed on to them by suppliers or passing them on to consumers. Many companies are choosing the latter course. Airlines are furiously tacking on charges for luggage, food, drink, blankets, and pillows. Hershey's, complaining of costs for sugar and other commodities that have risen between 20 percent and 45 percent so far this year, in August announced a 10 percent price increase. Frank Bruni  reports in Wednesday's New York Times that restaurateurs are substituting cheaper goods (shiitake mushrooms instead of morels, lump crabmeat instead of jumbo lump crabmeat) and keeping the prices steady. When you pay the same for smaller portions or for goods of lower quality, that's inflation.

So, no, the great inflation scare of 2008 isn't over. It may just be beginning.

© 2008