Fed Test: Will It Adjust in Time If Inflation Stirs?
The Wall Street Journal (9 October 2007)
Inflation jitters have spread through financial markets in recent weeks, fueled by the Federal Reserve's aggressive interest-rate cut last month as a persistent housing slump and the specter of a credit crunch increased fears of recession.Inflation doves appear to have data on their side for now. But the hawks may yet find cause for concern.After the Fed abandoned its early-August stance that inflation was the economy's biggest threat and cut interest rates by half a percentage point in September, some investors believed the central bank was stoking inflation. Bond yields rose. Market-based measures of inflation -- such as the difference between yields on government bonds that adjust automatically for inflation and those that don't -- indicated worries about upward price pressures.Commodities such as oil and gold surged. The dollar tumbled. Adding to those worries: Friday's report that hourly wages were up a hefty 4.1% from a year earlier."The Fed is pursuing a highly risky monetary policy," says Peter Schiff, president of Euro Pacific Capital, a Darien, Conn., brokerage firm that specializes in foreign investments. "Inflation is going to get a lot worse. People are going to be shocked...at what things cost."Yet measured inflation has moderated in recent months. The Fed's favorite inflation gauge, the price index for personal-consumption expenditures, rose 1.8% in August compared with a year earlier, within the 1% to 2% comfort zone of some central-bank officials and the slowest rate since early 2004. The increase was the same for the so-called core measure, which excludes food and energy prices. The biggest component in inflation measures -- housing costs, such as rent -- is facing downward pressure as the housing market continues its steep decline. A further slowing of the nation's economy should reduce firms' ability to raise prices. A softening job market, with unemployment inching higher, may hold back workers' demands for higher wages.
But some investors remain concerned about the possibility that a falling dollar, its downward drift accelerated by the Fed's rate cut, will feed into the prices that consumers pay. And a continuing increase in oil prices -- partly a reflection of a weaker dollar -- could push costs up for raw materials, leading to higher consumer prices in the long run. It also could play a more subtle psychological role: If consumers and businesses see costs rising, they may be more likely to push prices higher.Yet a recent study by Fed staffers found that foreign producers tend to lower their prices -- keeping them constant in dollar terms in the U.S. market -- when their currencies rise against the dollar. That minimizes producers' loss of market share and cushions American consumers from much of the rise in import prices owing to a weaker dollar. A top concern among central bankers is public inflation expectations. If businesses and consumers believe officials will take whatever action is necessary to prevent inflation from taking off, they are more apt to keep price and wage increases down -- even when oil prices jump or some other inflation threat materializes."Credibility is something that's extremely difficult to build up and extremely easy to lose," says Brandeis University Prof. Stephen Cecchetti. "The only way to build it up is by keeping inflation low when you say you're going to do it. "Consequently, a rise in inflation expectations could lead the Fed to hold off on further rate cuts or even consider raising rates if the economy regains momentum. Two commonly used measures of U.S. inflation expectations, one based on surveys of consumers and another on market movements, signal little concern. The University of Michigan's consumer-sentiment survey shows expectations about inflation in the long term -- five years -- at 2.9%, off its recent peak of 3.2%. And the difference between the yield on conventional Treasury bonds and Treasury inflation-protected securities, which are adjusted for changes in the consumer-price index, edged slightly higher immediately after the Fed cut interest rates, but then fell back. On Friday, bond yields rose again on inflation concerns about the jobs report. So the big question now in markets -- a concern exacerbated by Friday's stronger-than-expected employment report -- is: If the economy isn't as bad as the Fed feared, will the Fed take action quickly enough to prevent higher inflation? The Fed's actions during the 1998 market turmoil -- a series of interest-rate cuts -- helped stave off a recession at the time. The economy prospered but ultimately slowed with the tech-industry downturn. "The Fed was a little slow if anything to take the easing back, and then you got a little bit of overheating," says Stephen Stanley, chief economist at RBS Greenwich Capital. "It's a question of whether the Fed is willing to be symmetric on the upside and the downside. "Fed Vice Chairman Donald Kohn alluded to that concern in a speech on Friday. The economic weakness in the near term should increase competition in markets and reduce upward pressures on prices, Mr. Kohn said. But he also said the Fed "would be able to offset the cut in the federal-funds rate -- if it turned out to be larger than needed -- in time to preserve price stability."
