June 24, 2002

Is Now Really the Time to Fight Inflation?

Curbing inflation? What inflation? Don't they look at their own graphs? Everyone else seems to have started focusing on the fact that demand appears likely to grow more slowly than potential output.

Economist.com |

Looking both ways | Jun 24th 2002 | From The Economist Global Agenda

America's Federal Reserve meets this week to decide whether to leave interest rates on hold or raise them. Most economists think a rate rise is now a question of when, not if. But the central bank has to steer a difficult path between curbing inflation and helping recovery...

Looking both ways
Jun 24th 2002
From The Economist Global Agenda

America’s Federal Reserve meets this week to decide whether to leave interest rates on hold or raise them. Most economists think a rate rise is now a question of when, not if. But the central bank has to steer a difficult path between curbing inflation and helping recovery

IT SHOULD a winning combination—it is certainly one most central bankers only get to dream about. Yet the lowest interest rates for 40 years and subdued inflation have not yet brought about a golden age. Indeed, as the members of the main policymaking body of the Federal Reserve—America’s central bank—prepare to review interest rates this week, they can reflect, somewhat ruefully, that decisions on interest rates are currently as hard as they have ever been. A rise in interest rates this week is unlikely, but deciding when to act is going to be difficult.

America’s sluggish economic recovery is causing all the trouble. Once it became clear that the recession had ended, that group of economists who always like to look on the bright side were seduced into thinking that a strong recovery was on its way. Even the most optimistic economy-watchers could hardly believe the preliminary figures for growth in the first quarter of this year when these were released on April 26th. An annual rate of 5.8% seemed too good to be true.

It was—the first revision cut that to 5.6% and it is possible there will be a further change when the final figure is published on June 27th (the day after the Fed announces its interest-rate decision). Still, even the revised figure shows an apparently strong rebound. It is partly the contrast between that figure and the rather more mixed picture painted by subsequent data which has dampened enthusiasm about America’s growth prospects for this year. An unexpectedly large drop in retail sales in May—down by 0.9% compared with April—sparked near panic in some quarters: maybe the American consumer, whose addiction to shopping had kept the economy afloat for so long, was tiring or, worse, losing his nerve.

In fact, taken as a whole, the flood of data about America’s economic performance suggests that a more realistic view is of a very modest recovery this year. Some forecasters are now saying the rate of expansion during the year will be as low as 2%, far below the impressive performance of the first quarter, and well below The Economist’s most recent poll of private forecasters, who, on average, reckoned growth would be 2.9% in 2002.

Whatever the exact figure, modest growth is consistent with recovery from the mildest recession on record. Alan Greenspan, the powerful chairman of the Fed, has been arguing this for months now, and the apparently erratic nature of recent statistics—some better than expected, some worse—will not come as much of a surprise to him.

The uneven picture will make Mr Greenspan and his colleagues cautious, though. Having reached an almost godlike status and been given much of the credit for nurturing the long boom of the 1990s, Mr Greenspan was criticised in some quarters for failing to check what he had once famously described as “irrational exuberance”. One school of thought believes the Fed should have done more to check the excesses of the dotcom bubble towards the end of the 1990s by raising interest rates more quickly than it did.

When the economy nosedived at the very end of 2000, Mr Greenspan started to cut rates very aggressively. Eleven cuts last year meant that he was able to recover some of his reputation: the speedy relaxation of monetary policy was given much of the credit for the mildness of the recession. Mr Greenspan will not want to squander that credit by raising rates too soon and choking off recovery.

Talk of an interest-rate rise as early as last March soon died away. The debate now focuses on whether an increase will be delayed until September, later in the year, or even be postponed until 2003. Indeed, Lawrence Meyer, a Fed Governor until recently, was quoted in the Financial Times on June 24th as saying that a further rate cut might yet be needed at some stage. Much will depend on the progress of the recovery in the coming months.

But economic expansion is only one of the Fed’s responsibilities. Indeed, the Fed is relatively unusual among central banks in having an explicit legal responsibility for nurturing growth. Most central bankers focus almost exclusively on inflation. Ensuring price stability is also a clear statutory objective for the Fed, which is why, as the economy picks up, the Fed’s job becomes more complicated. How to keep inflation subdued and avoid dampening growth prospects is a difficult balance to strike.

Inflation presents no immediate worries, as the latest figures, published on June 18th confirmed. But that could change if the dollar remains weak, or slides still further. Since the beginning of the year, the greenback has lost around 8.5% of its value against the euro, and touched its lowest level for more than two years on June 24th. A lower dollar is good news for America’s exporters, but it pushes up the price of imports and so eventually feeds through into inflation. The economy’s burgeoning trade deficit shows just how fond Americans are of foreign products.

The Fed’s current dilemma—inevitable at an economic turning-point—has breathed new life into a debate about whether the American central bank should have, or publish, an explicit inflation target. One reason some economists are starting to think about this is because they are also starting to think about life after Greenspan. The current chairman’s reputation is generally so high that most people trust him to deliver price stability. After 15 years in the job he has built up a (largely) untarnished reputation.

His successor will clearly have no such track record—hence the call, so far very subdued, for the Fed to introduce inflation targets, or at least consider them, especially now that so many other central banks have adopted them. Such discussion is accompanied by gossipy speculation about who might succeed Mr Greenspan, whose current term ends in 2004. He has so far shown no sign that he plans to retire early, or even then.

But change is inevitable at some point. In the meantime, Mr Greenspan will be aiming to ensure that the Fed can husband the still-fragile recovery without letting inflation rip. This is not the time for blotting copybooks.

Posted by DeLong at June 24, 2002 08:11 PM


I'm not an economist, Brad, but speaking as an investor, I'm petrified of inflation, not in the abstract sense, but for very specific here and now reasons. Right now a long term bond, say a GNMA, is paying maybe 6.5%. There is a high chance this will go up quite a bit in the near future just because of foreigners losing faith in the US, and refusing to buy more US debt. This is already worrying for holders of such debt.

But far more worrying is that we have a situation that is tailor-made for a repeat of the 60s. A military situation that is leading to god knows what cost, along with a government that refuses to choose between guns or butter (in this case not because of the Great Society, but because of a low tax obsession, but the end result is the same). As the debt burden grows, it's obviously going to be very convenient for the Treasury to inflate that debt away. So can we rely on Fed to look out for the interests of the country as a whole? Well so far sure, but what happens if Alan Greenspan gets hit by a bus tomorrow and Bush nominates an Arthur Burns as his replacement. (Now maybe I'm being mean here, but everything I've read about Arthur Burns indicates that he was altogether too willing, when the White House said "jump" to ask "how high".)

This is an administration that has frequently indicated both its complete ignorance of matters economical, and its complete willingess to sacrifice everything to the alter of lower tax cuts. That's a scary crowd to have possibly choosing the direction the Fed will go.

Posted by: Maynard Handley on June 25, 2002 02:31 AM

Of course central bankers, Japan excluded, always have to say they are worried about inflation, for the same reason Treasury Secretaries have to say they like a "strong dollar". It is a mantra the markets expect.

The penalty for NOT saying the "magic phrase" is contextual chaos in the markets, as US Treas Secy O'Neill still seems to be learning.

And, as monetary policy famously has long and variable leads/lags, today's low rates must be evaluated in the framework of an unknown future economy.

Posted by: George Zachar on June 25, 2002 08:52 AM

But just because the Economist views itself as central bankers' favorite magazine doesn't mean it has to parrot all their expressed views, does it?

Brad DeLong

Posted by: Brad DeLong on June 25, 2002 09:26 PM
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