For the Fed, a Recession — Not Inflation — Poses Greater Threat
By Greg Ip
3 March 2008
The Wall Street Journal
(Copyright (c) 2008, Dow Jones & Company, Inc.)
Two fears hang over the U.S. economy: wrenching recession and spiraling inflation.
Yet history suggests the two almost never happen at the same time. And that explains why the U.S. Federal Reserve, for now, has chosen to focus on the first threat rather than the second.
Fed officials believe that those who say it is courting a return of 1970s-style “stagflation” — stagnant growth and inflation — misinterpret the lessons of that decade. The bigger test of Fed Chairman Ben Bernanke’s anti-inflation resolve may not be how much he cuts rates during a downturn, but how soon he raises them afterward.
Last week brought unrelenting bad news for Mr. Bernanke. New-home sales and consumer confidence tumbled while claims for unemployment insurance rose. Meanwhile, the Commerce Department reported that the price index of personal-consumption expenditures, the Fed’s preferred gauge of inflation, rose 3.7% in January from a year earlier, its second-biggest increase since 1991. More worrisome, “core” inflation, which excludes food and energy, accelerated to 2.2% in January from 1.9% in August. It has been above the 1.5%-to-2% range Fed officials define as price stability for 37 of the previous 46 months.
So why is the Fed more worried about growth than inflation? First, it thinks run-ups in commodity prices explain the increases, not only in overall inflation but also in core inflation: higher energy costs have “passed through” to other goods and services. Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising — they don’t have to actually fall — both overall and core inflation should recede.
So far, they’re still rising: wheat, oil and gold hit nominal records last week. But Fed officials don’t think the latest jump can be justified by fundamental supply and demand. U.S. inventories of crude oil and gasoline are plentiful. Strong demand from China isn’t new and should have been factored into prices long ago. A more likely explanation: investors, perhaps alarmed by the Fed’s dovish stance, are pouring money into commodity funds and foreign currencies as a hedge against inflation.
Such fears can be self-fulfilling as higher food, energy and import costs work their way into consumer prices. But speculative price gains can’t be sustained if the fundamentals don’t support them. If the Fed and the futures markets are right, prices will be lower, not higher, a year from now.
For the current high inflation rates to become permanent, the Fed believes it has to become embedded in how workers and businesses set wages and prices. So far, surveys suggest consumers haven’t raised their expectations of inflation much. In last year’s fourth quarter, hourly wages and benefits were up just 3% from a year earlier, a slowdown from 2006, even though unemployment was below 5% for almost all that period. A wage-price spiral requires wages to cooperate.
Wages are even less likely to accelerate if unemployment, now 4.9%, rises to 5.25% this year and falls only gradually to 5% by 2010, as the Fed’s Federal Open Market Committee forecasts. That implies three years with the unemployment rate above the FOMC’s estimated “natural” rate of about 4.9%, and thus steady downward pressure on inflation.
The notion that higher unemployment reduces inflation has its skeptics, even at the Fed. “All you have to do is recall the 1970s, when we experienced both high unemployment and high inflation, to appreciate that slow economic growth and lower inflation don’t necessarily go hand in hand,” Federal Reserve Bank of Philadelphia President Charles Plosser said last month.
Yet inflation did fall after the recessions of 1969-70, 1973-75 and 1980. In fact, Fed research has found that a given amount of unemployment had twice the impact on inflation then as now.
So why were both unemployment and inflation higher at the end of the 1970s than at the beginning? In the 1960s the Fed thought it could achieve lower unemployment by accepting slightly higher inflation. But the trade-off proved temporary. As workers adjusted their wage expectations to higher inflation, unemployment returned to its natural rate, which is determined by demographic and structural factors.
The Fed did raise interest rates when inflation rose, and the resulting recessions pushed inflation down. But because of political pressure, ignorance, or both, the Fed couldn’t tolerate high unemployment for long and quickly took its foot off the monetary brake, and inflation bottomed out higher than where it began. Workers and firms were quick to adapt to that higher inflation. It took the deep 1981-82 recession to break that inflationary psychology. When inflation expectations rise, “it is very costly to the economy” to get them down again, Mr. Plosser said.
Critics say the Fed also took too long to reverse the ultralow rates of 2001-2003, thereby fueling the housing bubble — if not rampant inflation — whose collapse now threatens the economy. Federal Reserve Bank of St. Louis President William Poole became one of the first people who participated in that decision to repudiate it. “With the benefit of hindsight . . . it is not hard to argue that the [Fed] was too slow to raise the federal-funds target after taking the target down to 1% in 2003,” he said at a conference on Friday.
Even Fed officials who don’t share that view agree that both that episode and the 1970s experience argue for promptly reversing rate cuts once the current crisis passes.
That’s easier said than done. The Fed is unlikely to face an outlook so unambiguously positive anytime soon that such a reversal will be a slam-dunk, and during an election year, it will face intense political pressure not to raise rates.
Whether the Fed reverses course “on an appropriate schedule” will be clear in five years or so, Mr. Poole said.
License this article from