Fed's Inflation Fears Might Trump
Calls for Another Big Rate Cut
Monetary-Policy Makers
Appear to Have Less Room
To Maneuver Than in Past
By GREG IP
January 4, 2008
Slowing factory activity, weakening job growth and a credit crunch have investors expecting aggressive interest-rate cuts from the Federal Reserve.
But this week's surge in the prices of oil and gold underlines why the Fed may not have the freedom to ease monetary policy as much as it did in 2001, when the economy slumped, or as much as many on Wall Street want.
The real disconnect is over inflation. The Fed thinks it is a bigger risk than it was in 2001, and bigger than Wall Street and many prominent economists think. That forces the Fed to accept a greater risk of recession than it did in 2001. That could mean either fewer rate cuts than anticipated by futures markets, which see the Fed's short-term rate target falling to 3% by year-end from 4.25% now, or a quicker reversal of the rate cuts.
Today's situation is in sharp contrast to the Fed's last rate-cutting cycle. In early May 2001, a survey of private-sector forecasters put the odds of recession at 35%. But by that point the Fed, under then-Chairman Alan Greenspan, had already slashed its target for the federal funds rate by two percentage points, to 4.5%, while declaring weak growth to be a bigger worry than inflation. The economy ultimately did experience a mild recession in part because of that September's terrorist attacks, and the funds rate ended the year at 1.75%.
Today, private-sector economists put the odds of recession at 38%, yet the Fed has cut the funds rate only one percentage point since August and has yet to say weaker growth worries it more than inflation.
Mr. Greenspan, who retired last year, said in a recent interview that inflation risks are much greater today than in 2001 and thus his successor, Ben Bernanke, has less freedom to shore up the economy with steep rate cuts than he did. "This is a much tougher monetary-policy environment than anything I experienced," he said.
The most obvious inflationary threat is from oil. It has risen to almost $100 a barrel now from $61 at the end of 2006. That has sent the 12-month overall inflation rate up sharply, to 4.3% in November. By contrast, oil hovered just at just less than $30 for most of 2001 before sinking after the Sept. 11 terrorist attacks, and inflation ended the year at 1.6%.
The Fed pays more attention to core inflation, which is less volatile because it excludes food and energy. But that picture is also troubling. Since April 2004, core inflation measured by the Fed's preferred price index has been at or above the top of policy makers' preferred 1.5% to 2% for all but five months, notes Doug Elmendorf, a former Fed economist who is now a scholar at the Brookings Institution. It dipped in the spring of last year before edging higher by year end.
The Fed, by allowing inflation to consistently run higher than its preferred range, risks feeding higher expectations of inflation in the public, which will make it harder to get inflation back down, Mr. Elmendorf noted.
Similar concerns bedevil the European Central Bank, whose ability to lower rates has been constrained by inflation of 3.1% in the countries that use the euro. The ECB aims to hold inflation just below 2%. (See related article.)
Perhaps the most important contrast with 2001 is one that gets little attention. Back then, the Greenspan-led Fed was optimistic that the spread of new technology had boosted worker productivity growth and thus the speed at which the economy could grow without bumping up against capacity constraints. Fed staff that June put the economy's noninflationary "potential growth" rate at 3.4%.
Since then, slower growth in both productivity and the labor force has led Fed policy makers to put potential growth at only about 2.5%. Thus, inflationary bottlenecks could develop at much more moderate growth rates than they did in 2001.
Vincent Reinhart, a former senior Fed staffer now at the American Enterprise Institute, said that pessimistic view of potential growth anchors officials' inflation concerns. It changes little between meetings, so it is discussed less than the rapidly changing prospects for growth. But Mr. Reinhart said the persistence of that concern is why the Fed has yet to put growth concerns clearly ahead of inflation in its postmeeting statements.
To many outsiders, the inflation concern is misplaced. "I see little chance of the kind of wage-price spiral that has set off inflation in the past," former Treasury Secretary Larry Summers, now a managing director at hedge-fund manager D.E. Shaw Group, said in a recent speech. "If I'm wrong and [easier monetary policy] creates undue inflation pressures, they can be removed gradually at a moment of much less financial peril."
Harvard University economist Martin Feldstein has also called for sharp cuts in interest rates, arguing that if higher inflation results, "the Fed would have to engineer a longer period of slower growth to bring the inflation rate back to its desired level."
But if inflation does rise as a result of overly easy monetary policy now, getting it back down could require much tighter monetary policy and even a recession.
"If in fact the economy bounces back fairly quickly and inflation remains elevated, then if monetary policy is very aggressive now, you might find yourself in a terribly inflation-risky environment later next year," Federal Reserve Bank of Philadelphia President Charles Plosser, one of the Fed's most hawkish policy makers, said in a recent interview. And if inflation expectations rise, getting them back down "might prove to be costly."
Mr. Bernanke, whose term is up for renewal in 2010, certainly wants to avoid a recession. But he would probably prefer a mild recession now to a high risk of increased inflation and a deeper recession later.
Write to Greg Ip at greg.ip@wsj.com |
