A SHARP-EYED

inflation hawk is suddenly cooing like a dove. William Dunkelberg, chief economist for the National Federation of Independent Business, has been closer than most to the bull's eye with his predictions for higher-than-expected core inflation and employment over the past year-and-a-half. Now he sees both measures falling in 2007 good news for the inflation fighters at the Federal Reserve.

Dunkelberg thinks the core rate, which excludes food and energy prices, looks as though it will drop from 2.6% to below 2%, within the Fed's so-called comfort zone. Back in July, the economist saw the core rate headed above 4%. Wage pressures will ease as the unemployment rate this quarter creeps closer to 5% from its current level of 4.5%. These trends portend a probable decline in interest rates.

Dunkelberg, who also teaches economics at Temple University in Philadelphia, produces a Small Business Optimism Index on a monthly and a quarterly basis for his trade group. His 33-year-old survey has an outstanding track record of anticipating inflation and employment trends, and thus is considered "must reading" by the investing, business and economics cognoscenti.

The Federal Reserve Board gets the first look at the coveted data before Dunkelberg posts it on the Web. "I used to share it personally with the chairman of the board," says Dunkelberg, a good-natured, self-effacing man and a fine bass fisherman. (He's one of 15 financial experts with whom we drop a hook and line each summer at Grand Lake Stream, Maine.) "I expect this will continue under Fed Chairman Ben Bernanke or maybe not," he chuckles.

When the Fed was being lambasted by pundits for raising rates instead of cutting them, Dunkelberg's data supported the view of the central bankers that core inflation was running higher than indicated by the Bureau of Labor Statistics. Government economists, he contends, were overweighting falling rents while underweighting a historical increase in home ownership and its impact on housing prices.

Dunkelberg's December survey, based on responses from more than 400 small businesses across the U.S., indicates a slower domestic economy ahead. December's survey shows that the number of firms raising average selling prices fell to 8% from 17% in the November survey, representing a major reduction in inflationary pressure if it holds up in the January data.

"Hedonics, imputations and all that fancy stuff aside, inflation is about firms raising or cutting their selling prices," says Dunkelberg. Back in 2003, when the inflation rate shown by the consumer-price index was 2%, some 35% of small business owners were raising average selling prices. When the economy was experiencing double-digit inflation in the late '70s and early '80s, as many as 70% of owners reported raising prices. Last year, the portion of owners raising prices peaked in April at 26%.

Dunkelberg's survey indicates that over the next three months, only 14% of firms plan to create new jobs, down three points from November and nine points from October. This, he says, is a clear signal that the unemployment rate will start to rise in the current quarter.

It's further confirmation that the economy is headed for a soft landing. Chairman Bernanke should start cooing, too.