Since 1979, when Paul A. Volcker took the helm at the Federal Reserve, the mission of the central bank has been clear: to beat inflation down by repeated clubbings with the monetary policy truncheon.
It's time to celebrate the Fed's success. By its own definition, the long fight for price stability has been won, convincingly. The latest numbers from the Bureau of Labor Statistics show that core inflation--outside of food and energy--rose only 2.6% from January, 2001, to January, 2002. Over the past five years, it has been hovering around 2.5% or so (chart), with no sign of either an inflationary surge or a deflationary spiral. Inflation is no longer a factor in long-term decision-making by companies, consumers, and investors. And as Fed Chairman Alan Greenspan has argued, that means the U.S. is effectively at price stability.
But now, having reached the equivalent of economic Valhalla, the Fed's job may have gotten more complicated. As the U.S. heads out of this downturn, low inflation poses new problems for monetary policy that no one at the Fed has faced before. "The Fed was like a dog chasing the inflation bus," observes Paul McCulley, chief economist at Newport Beach (Calif.) money manager PIMCO Advisors. "Nobody ever thought they would catch it." And in some ways, stability creates difficulties for corporate managers, too.
Of course, no one wants to go back to the bad old days of high inflation. With price increases small, borrowing is cheaper because interest rates are lower. Productivity improves as companies, unable to pass along costs as higher prices, are forced to operate more efficiently. And most important, prices become a better guide to allocating corporate resources. "If you have inflation, it's hard to separate out how much of price changes are noise and how much are demand-driven," says Neal Soss, chief economist at Credit Suisse First Boston.
But having reached price stability, maintaining it does require a change in the Fed's mindset. Over the past 20 years, the Fed has pursued a policy of "opportunistic disinflation" when coming out of recessions. After a downturn would dampen inflation, the Fed would tighten credit in the recovery to ensure that prices didn't shoot back up. Such a policy worked well after the 1981-82 and 1990-91 recessions, when core inflation was above 4%.
But now, with inflation already low, the Fed faces a quandary. The federal funds rate, now at 1.75%, obviously has to be raised as the economy recovers. But aggressive tightening could push inflation down too low, sending some sectors of the economy into deflation--that is, falling prices. On the other hand, going light on the monetary brake could potentially create future risks. With little inflation priced in, short-term interest rates could stay low even as the recovery gets into full swing--perhaps as low as a fed funds rate of 3% to 4%. That wouldn't leave much room for the Fed to cut when the next slowdown comes.
That may be why the Fed seems unusually divided when signaling what it's going to do over the next few months. "My foot isn't heading for the brake yet," says Minneapolis Federal Reserve President Gary H. Stern. On the other hand, Atlanta Federal Reserve Bank President Jack Guynn stated in a Feb. 14 interview with financial media network Bloomberg that he was pleased the bond market appeared to be pricing in a tightening of roughly a half-percentage point by September.
But it's not just the Fed that's going to have to change its practices because of price stability. If corporate execs can't raise prices, they face new problems as well. For one, inflation lower than 3% is historically associated with deteriorating earnings and rising bond defaults, says Soss, based on data from 1920 to 2000. "So much of our financial structure requires that people have enough pricing power to meet their debts," he says. "If they don't have it, then credit problems begin to surface."
Moreover, with inflation low, corporate managers may need to learn new ways to cut labor costs. In high-inflation periods, a wage freeze was good enough to do the trick. "In the 1970s, a wage freeze meant wages were actually falling by 10% a year," says Laurence M. Ball, an economist at Johns Hopkins University. In today's economy, a wage freeze would cut real costs by only 2%. Since it's hard to persuade workers to take a pay cut, corporations may have to be more aggressive about cutting jobs.
Right now, it may be premature to worry about the problems associated with long-term price stability. One issue is whether the fight against terrorism pushes up prices as resources go into security rather than production. "There's an inflationary aspect to war," says Soss.
But for now, there's no sign of runaway prices. The era of price stability--with its pluses and minuses--is likely to be here for a while, and people are going to have to get used to it.
By Margaret Popper in New York