Economy faces that '70s feeling again; Fed has a big challenge
By Kevin G. Hall | McClatchy Newspapers
WASHINGTON -- Not since the 1970s has the U.S. economy faced such an ugly combination of a persistent energy shock, a looming recession threat and menacing inflation that stays stubbornly high -- even in the face of a screeching slowdown in growth.
This combination has the Federal Reserve, charged by law with both sustaining growth and curbing inflation, in a bind. It must balance the needs of protecting the economy from a downturn while protecting it against an upward spiral of prices — and doing either one can make the other far more difficult.
In addition, this dilemma comes amid the worst housing slump in modern times, as well as an unprecedented crisis in credit markets whose positive outcome is far from certain. Adding to the troubles are the dive of the U.S. dollar against other currencies and rising global inflation that partly mutes whatever action the Fed takes.
"This thing has the potential to really unwind to create huge negative effects," said Lyle Gramley, a former Fed governor from 1980 to 1985, one of the U.S. economy's most turbulent periods. "The Fed is walking a tightrope right now, that's for sure."
Laurence Meyer, a Fed governor from 1996 to 2002, sees some parallels between today and the late 1970s and early 1980s, when the oil-dependent U.S. economy saw double-digit inflation largely because of an unexpected energy shock. Growth fell while inflation rose, creating stagflation -- a stagnant economy and high inflation.
Today's problems, he said, reflect "the first really persistent (oil) shock we've had since the 1970s, and the inflation expectations are worse than we have had over the past decade. So we're kind of in a middle area."
Neither Meyer nor most other prominent economists expect a return to double-digit inflation. Policymakers learned from the Fed chairman back then, Paul Volcker. He pushed interest rates up so high that they crushed double-digit inflation. But it came at a huge price — the job-killing 1981-82 recession, worst since the Great Depression. To kill inflation he first had to squash growth.
But once the inflation dragon was slain, the '80s economy boomed, and Ronald Reagan won a landslide re-election in 1984 on the slogan that it was "morning in America."
Today there's no chance that Fed Chairman Ben Bernanke will ignore inflation; the question is how long will its rise will be tolerated before he acts to tame it.
Pressure is growing on him to act soon.
"We need to take steps to ensure that inflation does not get out of control. We need to act pre-emptively," Charles Plosser, president of the Federal Reserve Bank of Philadelphia, told CNBC television on Thursday.
He said that the Fed should raise interest rates soon to quell inflation. But that could tip the economy into recession if it's not already there, or make it worse if it is.
Yet failing to raise interest rates could make things even worse over time. It could permit an inflationary spiral to ignite as consumers and businesses demand higher wages and prices to compensate for the inflation they're already feeling.
That would fuel, in turn, even-higher inflation, which in turn would require even higher interest rates and a deeper recession, as happened in 1981-82.
In a June 9 speech, Bernanke said he'd "strongly resist an erosion of longer-term inflation expectations, as an un-anchoring of those expectations would be destabilizing for growth as well as for inflation." That means that he'll raise rates quickly if consumers and businesses show signs that they're beginning to expect inflation will keep rising.
"That's recognizing the important thing that went wrong in the '70s. But he's not saying it has happened yet," said Meyer, who expects rate hikes only after it is clear that the U.S. economy is on more stable footing and that recession threats have eased.
That view is shared by Alice Rivlin, a Fed vice chairman from 1996 to 1999. She's struck that inflation isn't worse. The May inflation report released Friday showed that the closely watched core inflation - which excludes volatile food and energy prices - grew only modestly.
"The amazing thing about this oil shock is it has not had very much impact on inflation. It's beginning to have some, but it's very mild compared to the last time," said Rivlin.
"It is similar to the '70s, but it's been a long time since we have had the coincidence of rising prices and a softening labor market," she said. "That's what is unique about now."
The softening labor market, Rivlin suggested, makes it unlikely that wages will chase rising prices - the normal pattern of an inflationary spiral.
Bernanke has aggressively slashed short-term interest rates in response to a weakening economy. Since last August, the Fed's benchmark federal funds rate - an overnight rate that banks charge each other — has fallen from 5.25 percent to 2 percent.
Still, headline inflation - the rise in prices consumers see at the cash register - is 4.2 percent since May 2007, and the core inflation rate, without food and energy prices, is 2.3 percent over the same 12 months. That's above the Fed's comfort zone of a 2 percent annual rate.
The recent surge in oil prices threatens to raise prices of food and manufactured goods even higher. Dow Chemical recently announced 20 percent price hikes because of rising oil costs. That's why inflation hawks like Plosser call for a pre-emptive strike now.
Such a move seems a matter of when, not if. While a rate hike is not expected when the Fed's policy committee meets June 24-25, the odds will increase with every meeting after that.
"The big test will be, are they willing to be symmetrically aggressive. They were aggressive on the downside and will they be aggressive on the upside," said Vincent Reinhart. Until recently he was the chief economist for the Fed's rate-setting Federal Open Market Committee (FOMC).
One advantage to hiking interest rates now, even amid a slow economy, is it would drive up the value of the dollar. The weakening dollar is a factor in high oil prices, as oil producers demand more dollars per barrel. Raising interest rates would lift the dollar, likely driving down oil prices. While higher lending rates dampen economic activity, the lowering of oil and gasoline prices would bring relief to consumers.
Fed policymakers in April projected a dismal growth rate for 2008 of between 0.3 percent and 1.2 percent. That forecast implies that the slowing economy will dampen inflation's embers before they ignite into fire.
That suggests "no tightening (of interest rates) until the end of the year," said Reinhart, now a senior fellow at the American Enterprise Institute, a conservative policy group.
But what happens if a hurricane rips through the oil-rich Gulf of Mexico later this summer? Researchers for investment bank Goldman Sachs & Co. predict that'd send oil to $200 a barrel. And $200 oil would send all kinds of prices skyward, creating the potential for 1970s style inflation.
"That really gives the Fed very big headaches, because $200 oil is going to set back the economy big time and the U.S. big time," said Gramley, the Reagan-era Fed governor. "There just aren't any easy options in this case."
SIDEBAR BOX (165 words 5")
Factors affecting inflation -- the rise in prices across the economy.
Rising oil price: Makes virtually everything that we eat or make more expensive. Oil prices affect the costs of plastic, packaging, chemicals, fertilizers, transportation and sundry other products.
Weak dollar: Makes imports more expensive, adding to inflation. The weak dollar is also partly to blame for high oil prices since foreign producers demand more dollars for the same barrel of oil to make up for the dollar's diminished value.
Economic slowdown: Bad for consumers and business, good for inflation. Slow growth moderates inflation, which ticks up as the economy heats up.
Imports: For the last 15 years, low-priced imports have kept inflation low. Shoes, clothing and electronics made in Asia cost Americans jobs, but also lower costs of products we buy. China is now facing its own inflation problem, with an official rate near 8 percent, which translates into higher-priced imports for American consumers and adds to inflation pressures here.
McClatchy Newspapers 2008
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