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Greenspan Has No Reason to Rush

Christopher Farrell Wall Street is filled with foreboding over inflation. The fear is that a storm of rising prices is gathering momentum with the economy strong and hiring improving. Industrial commodity prices are high, oil is at nosebleed levels, and the benchmark consumer price index surged to a 5.1% annual rate during the first three months of the year. The nervous clamor on Wall Street for the Federal Reserve to actively combat inflation is getting loud and vociferous.

Yet the Fed decided to keep its benchmark interest rate at a four-decade low of 1% at its latest policy gathering on May 4. The central bank did send a clear signal to the market that a rate hike is coming (see BW Online, 5/5/04, "A Less 'Patient,' More 'Measured' Fed"). But many money managers, economists, journalists, and other market commentators are getting impatient.

"From the parochial view of a stock market bull, I'd just as soon get this out of the way," says Edward Yardeni, chief investment strategist at Prudential Securities. "Do it."

FLASHBACK. It likely won't happen that quickly. The Fed is taking a careful approach because the cost of credit is going up during an economic expansion that's gaining traction, and the market has already hiked rates. The Fed will eventually follow. But it needn't worry about the overall price level. The central bank is right to stick with a cautious course.

That was a key lesson from the 1994 aggressive round of rate hikes. Like now, memories of that recent recession were fading at the time. Prices of visible commodities such as coffee, cotton, and basic materials were up sharply. China's economy was booming. The American output was expanding at a healthy clip. The unemployment rate was heading lower. Taken altogether, inflation was inevitable, thought Wall Street economists and investment strategists.

So did the Fed. So, it hiked its benchmark rate eight times from February, 1994, to February, 1995. What happened? The monetary tightening sparked a bond-market crisis for the record books. The economy nearly swooned into recession, forcing many workers to wait even longer for a job and stalling management expansion plans. As for inflation, it was a false alarm. The overall price level went lower.

CHINA WATCH. The current inflation scare has all the makings of another mistaken distress signal. The numbers suggest that the rise in commodity prices has peaked. The Baltic Freight Index, a widely followed indicator of shipping rates and a harbinger of global commodity price trends, is down sharply from its recent high. So are copper prices and other commodities.

China's white-hot economy, a major factor behind soaring commodity prices, is likely to slow down in coming months. Beijing's central bank is tightening monetary policy to cool off the Asian nation's business and speculative fever. The demand for commodities will ease if the People's Bank of China engineers a soft landing.

In fact, prices could collapse in the event of a hard landing. American companies have been able to push through to the retail shelf at most 13% of the higher commodity prices rises they're paying, according to calculations by economists at Merrill Lynch. That compares to an average 30% pass through to consumers during previous commodity booms over the past three decades.

STAY THE COURSE. It's hard to see a sustained rise in the overall price level with labor costs well under control. The accelerating trend toward outsourcing blue-collar and white-collar jobs to low-cost, high-skill workers in developing nations like India, China, and Malaysia is keeping a lid on skilled worker wages. Productivity growth has averaged 3% a year since 1995 and 3.6% over the past five years, a performance that gives companies plenty of leeway to maintain profit margins and keep selling prices stable to lower even if management does raise wages.

The current strength of the economy and job market shouldn't be exaggerated, either. It will take months of strong hiring to bring discouraged workers back into the applicant pool, and many more months after that for all of them to land a steady paycheck. And while the high price of oil and gasoline is taking disposable income out of consumers' pockets, it's putting downward pressure on economic activity.

Inflation, Nobel laureate Milton Friedman has taught a generation of economists, is always and everywhere a monetary phenomenon -- too much money chasing too few goods. But the money supply is well under control, expanding at a 4% to 6% rate year-over-year. Most important, fast economic growth and more employment don't devalue the currency. The Fed is right to take a go-slow approach, despite the din of voices calling for quicker action. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

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