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Inflation: Monster Or Myth?

This column was written by Irwin M. Stelzer.


So it has finally happened, just as the nay-sayers said it would. A memo is leaked suggesting that Korea's central bank is considering switching out of dollars, and the value of the U.S. currency drops. Unexpectedly weak job market and retail figures hit the wires, and the experts scramble to be first in print with downward revisions of their growth-rate forecasts. Economists at a leading investment bank muse out loud about $100 oil, consumer prices tick up one month, and the inflation hawks circle the Fed. A few companies open the earnings-reporting season with bad numbers, and investors scramble for safety.

The good news is that the bad news isn't all that bad, as investors seem to be realizing. The Korean central bank denied that it plans a massive unloading of dollars, and monthly jobs and retail sales figures are notoriously volatile. Oil prices have headed down, not up, since the much-reported $100 forecast, and the Saudis are promising to step up investment and production. As we have gotten deeper into the earnings-report season, the corporate profits picture turns out to be rosy, if unspectacular.

Which brings us to inflation. Last month core consumer prices (excluding food and energy) rose by 0.4 percent, twice the rate economists had been predicting, bringing the annualized 3-month increase to 3.3 percent, which, if maintained, is above the rate that would allow Fed chairman Alan Greenspan to relax when indulging himself in his habit of writing his speeches while having a good soak in the bath. More important, the index that the Federal Reserve Board's monetary policy committee watches has been rising steadily, at about twice the rate of a year ago. In the most recent survey of its 12 business districts, published last week, the Fed notes, "Price pressures have intensified in a number of districts."

Add to that picture anecdotal evidence that some of the nation's largest companies are recovering pricing power, and oil inventories so low that prices are likely to rise further during the summer driving season, and you have reasons that inflation worries are more than just imagined things that go bump in the night, to borrow from an old Cornish (some say Scottish) prayer.

But ask the wrong question, and you get a not very useful answer. The wrong question is, have prices been rising more rapidly of late? Answer: Yes. The right question is, will the recent behavior of prices force the Fed to abandon its policy of steady, "measured" quarter-point increases in interest rates, and drive long-term interest rates up to growth-retarding levels? Answer: probably not. Here's why:

The most obvious reason is that one-month, or even a few months, do not make a trend, especially when anyone with some memory of the behavior of prices in recent years analyzes the figures. The recent one-year increase of 2.3 percent might seem dramatic to "traders who graduated in 2002," but "for anyone with even one grey hair, most of their lives have been spent thinking that a 2.3 percent inflation rate is something close to an unattainably low ideal," reports the Lindsey Group in its latest advisory.


It is certainly true, as Fed vice chairman Roger Ferguson told the press, that "There are emerging signs of inflation [and] we need to track pricing developments quite closely." And when the Fed does that tracking it will notice that almost all of last month's increase in the core price index was due to a rise in hotel rates, not a particularly threatening development. More significantly, it will note that commodity inflation, which peaked at an annual rate of 34 percent last spring, is now down to a trivial 1 percent annual rate.

The bank's policymakers will also notice that the Fed's recent survey revealed, "overall, manufacturers' output prices appear to be rising modestly," and reported that in several areas of the country there were instances of "firms having to rescind price increases and accept lower margins."

In short, the evidence that inflation has reached dangerous levels -- evidence that panicked traders -- is far from conclusive. Indeed, there is significant evidence to suggest that what lies ahead is a period of disinflation -- a slowing in the rate of price increases.

Over the past three years, the economy has been fed the steroids of loose fiscal and monetary policy. During that period, it has managed to grow at something like 3.25 percent to 3.50 percent -- about in line with historic trends. Now that the deficit is shrinking relative to GDP, the fiscal stimulus is fading. And at the same time, the Fed has begun monetary tightening,

Those policy changes, along with the drag on consumer spending from gas prices that are likely to close in on $2.50 per gallon this summer, make it improbable that the economy will grow so rapidly as to fuel inflation.

Perhaps most important, the global economy is awash in capacity. On the goods side, China and other Asian countries have an almost infinite capacity to supply the world with more and more goods without significantly raising prices, even if labor costs in China do edge up. And on the capital side, the world is experiencing a glut of savings, funds ready to pour into the United States in response to a rise in interest rates.

Does all of this mean that we can wipe inflation off our worry list? No. After all, consumers have proved a resilient bunch, business spending on equipment is rising, and a point might be reached at which oil prices turn up and begin to filter through to final product prices.

But for now, the Fed has to worry that if it tightens too much, too rapidly, it will create a deflationary cycle in which prices spiral downward, discouraging business investment, and inducing consumers to wait, and wait, and wait for still lower prices. That spells recession.

So the Fed team in charge of steering the economy is likely to prefer "steady as she goes" to a change in direction. Not a bad decision.

Irwin M. Stelzer is director of economic policy studies at the Hudson Institute, a columnist for the Sunday Times (London), a contributing editor to The Weekly Standard, and a contributing writer to The Daily Standard.

By Irwin M. Stelzer
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