Vigilance From The Fed Not Zeal

Two disparate economic events are about to make a big impact on our lives. Pricing power suddenly returned to at least one big segment of the American economy as steel companies successfully pushed through a hefty 10% hike to Detroit. Across the Pacific, interest rates began rising in Tokyo, signaling that Japan, like the U.S. and Europe, is once again expanding.

Remember synchronous growth? It's back. But it's bigger this time with the integration into the international market economy of former communist and statist countries. China, Eastern Europe, Latin America, Southeast Asia, the Middle East, and even South Africa are all growing, triggering talk of a global capital shortage in the Washington-Wall Street circuit.

Both events are bound to make the life of Federal Reserve Chairman Alan Greenspan a lot harder in the months to come. Inflation hawks at the Fed will probably see them as further proof that higher interest rates are needed. They believe that the economy is growing at a faster clip than most private economists hold. Odds are, when the Fed meets on Aug. 16, it will raise rates yet again. If the Fed is right about the economy, the hike won't be enough to derail the expansion.

But the stakes keep rising for any further tightening of the monetary faucet. The recovery, now in its third year, is showing signs of wear and tear. Higher interest rates have slammed new home sales. New car sales are off their highs. Retail sales have softened, and productivity gains may have peaked for this business cycle.

Inflation, the clearest sign of an overheated economy, has yet to spread its poison. Despite big payroll employment gains, unit labor costs remain extremely low. And while prices for industrial and agricultural commodities have gone up, manufacturers are afraid to pass the hikes along to customers. So far, growth is not generating inflation.

The Fed's game to date has been to get ahead of inflationary pressures early. That strategy meant moving from an accommodative to a more neutral monetary stance. Now the game may change to engineering a "soft landing" as the U.S. expansion matures. Further rate hikes will bite hard, especially as fiscal policy remains tight.

It behooves the Fed to be vigilant as the world economy shifts into higher gear, and as pricing power makes a more frequent show at home. But stakes are growing for any miscalculation in monetary policy. The U.S. growth rate already appears to be downshifting to 2.5% for the second half of the year from 3.5% in the first six months. Any mistake in monetary policy after Aug. 16 could be very costly.

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