Greenspan Isn't Worried -- Yet

Strong productivity and continued excess capacity should keep inflation in check, says Greenspan. Will they?

Suddenly, prices seem to be popping up everywhere. Whether for coffee, lumber, paper towels, or tickets to Disneyland, companies are finding that the booming economy is giving them leeway to jack up prices for the first time in years. That's showing up in higher inflation. On Apr. 14, the government said consumer prices jumped 0.5% in March, bringing first-quarter inflation to an unsettling 5.1% annualized rate, vs. just 1.9% last year.

Yet inside the marble-halled Federal Reserve Board, Chairman Alan Greenspan and his colleagues seem downright sanguine. Despite growing worries on Wall Street that an inflationary storm may be getting under way, Fed policymakers see the recent price rises more as a welcome sign that troubling deflationary forces are dissipating. With productivity strong, profit margins fat, and a surfeit of capacity in the economy, an inflation spiral looks unlikely, they argue. "Significant productivity growth and a sizable margin of underutilized resources should continue [to hold inflation in check] for a while," Greenspan told lawmakers on Apr. 21.

A lot depends on Greenspan & Co. being right. If inflation truly isn't a problem, then the Fed can take its time raising rates from the current 46-year low of 1%, perhaps starting with an increase in August, followed by gradual bumps to around 3 1/2%. That would give financial markets and the economy time to adjust to the end of cheap money.

POLITICAL RAMIFICATIONS. But if the Fed is wrong and inflation is taking off, as critics increasingly fear, then watch out. In that case, the central bank would be forced to hike rates swiftly and significantly, hammering bond and stock prices and undercutting a housing market that even some Fed officials fear is too frothy. It would also send shock waves through the global economy, where a number of countries -- most prominently China -- have effectively tied their monetary policies to the Fed by pegging their currencies to the dollar. Such a move could have political ramifications, too, perhaps costing President Bush the election.

Fed officials admit they were surprised by the March jump in consumer prices. Even after stripping out volatile food and energy costs, prices were still up 0.4%. But Fed insiders took comfort from the fact that part of the outsized increase in March's consumer-price index was due to special factors -- a 0.9% rise in apparel prices and a 3.8% jump in hotel-room rates -- that are unlikely to be repeated.

Why do they believe the fundamentals argue against sustained inflation? Even after the spurt of growth over the past nine months, the economy is awash in excess capacity that limits companies' ability to hike prices. The Fed reported on Apr. 16 that capacity utilization at industrial companies actually slipped, from 76.7% in February to 76.5% in March -- still comfortably below the long-term average of more than 80%.

There's plenty of slack in the jobs market as well, even after the 308,000 increase in payrolls in March. Sure, the unemployment rate has fallen from a high of 6.3% last June to 5.7% now. But much of that slip represents discouraged workers dropping out of the workforce. If labor-force participation were at the levels it averaged in the '90s, the unemployment rate would be over 7%, according to International Strategy & Investment Group Inc., a New York institutional broker.

Strong productivity growth also continues to help control labor costs. Chris Varvares, president of consultant Macroeconomic Advisers, reckons that unit labor costs fell at a year-over-year rate of 1.6% or more in the first quarter, thanks to increases in efficiency.

Together, these factors should restrain salary increases. That's crucial to preventing an inflationary wage-price spiral. Since labor accounts for about 70% of business expenses, a rise there would be far worse for the economy than the price hikes now seen in commodity markets or consumer goods.

Of course, labor costs are likely to rise as productivity growth slows and the jobs market revives. But Fed officials don't see companies raising prices to make up for the higher wage bills, thanks to plump margins. According to the Commerce Dept., margins at nonfinancial companies were their widest in six years in the fourth quarter. While businesses enjoy big markups, they know rivals are equally flush. So everyone raising prices knows that a competitor could undercut them.

COTTON TO COPPER. Is the Fed right about pricing? The risk is that companies will discover they can raise prices faster and higher than the Fed expects. Already, a host of businesses are finding that they have the power to push through price increases -- and they're doing it. Nearly a third of the outfits contacted by the National Association for Business Economics (NABE) reported boosting prices in a survey released on Apr. 20. "Selling prices moved noticeably higher in the last quarter," says Duncan Meldrum, NABE president and chief economist for industrial gas maker Air Products & Chemicals Inc. (APD ).

The move started with commodities, where strong demand from China helped push up prices on everything from cotton to copper. But now it's filtering up the supply chain as companies take advantage of the booming U.S. economy to pass along higher raw-material costs. "There is a bit different dynamic in the marketplace," says Patrick D. Campbell, chief financial officer of industrial conglomerate 3M Co. (MMM ). "People are trying to raise prices."

Even long-depressed industries are finding they can push through price increases. Take hotels: Paula Drum, vice-president of hotel strategy at travel and real estate services conglomerate Cendant Corp. (CD ), says the company "is beginning to see some rebound" in room rates. Airlines, too, are benefiting. "Finally we've got enough demand where there's at least a chance you could have some strengthening yields," says Southwest Airlines Co. (LUV ) CFO Gary C. Kelly.

All the talk about a return of corporate pricing power has inflation-phobes in the bond market twitching. A growing cadre argue that the Fed has let the inflation genie out of the bottle by waiting too long to tighten credit. "The Fed is behind the curve," says economist Ramachandra Bhagavatula of the Royal Bank of Scotland. "Inflation is rising, and the economy is booming." Investors seem to agree. Prices on inflation- protected securities issued by the Treasury suggest inflation expectations have doubled since the start of 2003, to more than 2.4%.

Critics also charge that the Fed is far too optimistic about productivity growth. Much of the recent spurt in productivity was temporary, in response to savage cost-cutting that can't last, they say. As productivity falls, labor costs and inflation will rise. What's more, they argue, there is far less slack in the economy than the Fed maintains. Since it takes a year or more for Fed rate hikes to affect the economy, Greenspan & Co. have already waited too late to move, they say.

It's a time-honored maxim in monetary-policy circles: A central banker's job is to take away the punch bowl just when the party gets going. Greenspan has always been reluctant to play that role. In 1987 and 1998, he opened the taps in response to financial crises, but he then let the elixir of easy money flow too long, leading in the first case to faster inflation and in the second to a stock market bubble. And in 1994, the partygoers got so wild that he had to clobber them with a doubling of interest rates, causing havoc in the bond market.

As Greenspan prepares to raise rates near the end of his 17-year run at the Fed, he is once again reluctant to snatch away the punch bowl. Let's hope this time he has it right. The direction of the economy -- and his legacy as a central banker -- depend on it.

By Rich Miller in Washington, Wendy Zellner in Dallas, Michael Arndt and Robert Berner in Chicago, and bureau reports

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