U.S.: Chill Out: Inflation Is Still Pretty Tame

Greenspan, despite some concerns, expects interest rates to rise gradually

For the first time in years, inflation is back on the radar screen. Be assured that recent blips are getting plenty of attention from the Federal Reserve, whose job it is to keep inflation under control. Almost all of the price indexes, from raw commodities to wholesale finished goods to retail items and services, have risen faster in the past year than they did in the previous year. As a result, pressure on the Fed to tighten policy by raising interest rates already is building.

But the aim is not to rein in an out-of-control economy. In fact, recent data suggest the economy is moderating from its souped-up pace of late last year. Rather, the Fed's goal is to remove the unprecedented degree of policy accommodation that was necessary back when deflation looked like a threat. Now the Fed wants to take policy back to neutral -- a level of interest rates that is neither accommodative nor restrictive to economic growth.

To that end, the key question about monetary policy is not how much further the Fed will have to raise rates, after already hiking the federal funds rate by a quarter-point, to 1.25%, on June 30. Almost all economists agree the Fed will have to lift its funds target by as much as three percentage points in the coming year or so.

The crucial question is how fast policymakers will have to move. Will the Fed be able to lift rates at its recently projected "measured pace," generally taken to mean a series of small quarter-point hikes? Or will it have to move more aggressively? The latter approach could prove dangerous, since it could disrupt the financial markets and harm the economy.

THAT'S WHY ALL EYES were on Fed Chairman Alan Greenspan on July 20-21 during his semiannual report to Congress on monetary policy. As widely anticipated, Greenspan sounded a generally upbeat tone on the economy and inflation, suggesting that the Fed will be able to move gradually.

While recognizing that some degree of business caution still lingers, Greenspan pronounced the recovery "self-sustaining," in no small part because of stronger job markets. And on inflation, the Fed chairman reiterated his belief that some of the recent inflation pressures were transitory, reflecting pricier energy and the indirect impact of more expensive energy on business costs.

What was new in Greenspan's testimony was his increased attention to the possibility of more aggressive tightening on the chance that current expectations for good growth and low inflation are wrong: "We cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation."

The Fed Sees Blue Skies Ahead
In fact, Greenspan cautioned that some of this year's pickup in inflation may not be transitory, but that it could be related to stronger demand, which is a more fundamental and longer-lasting inflation factor. He predicted demand in the second half will bounce back from its spring lull. In particular, he said the softness seen in consumer spending will prove short-lived. Bond market players reacted negatively to Greenspan's slightly more hawkish caution: They pushed long-term rates higher on the Fed chief's remarks.

But Greenspan made it clear that his basic view of the inflation outlook was favorable. He argued that slack in the economy and intense competition will limit price increases. He said that, for now, unit labor costs are not rising fast enough to threaten price stability over the long haul. Plus, because profit margins are exceptionally high, he thinks businesses have plenty of room to absorb higher costs, without jacking up prices.

THE FED'S OFFICIAL FORECAST, which is based on the central tendency of the policymakers' individual projections, sees nothing but blue skies. In a nutshell, the forecast is for solid economic growth, stable inflation, and a continued, gradual drop in unemployment (table).

One interesting implication of the Fed's forecast is that growth in real gross domestic product will have to speed up in the second half to meet the policymakers' projections. Such a view runs counter to the recent spate of economic numbers. The June reports on employment, retail sales, and industrial production, all looked weak. But the Fed's forecast suggests that the policymakers think the disappointing data overstate the degree of the economy's slowing. Indeed, the recent monthly trends of all the key data appear much stronger, so the Fed's forecast might not be too far off the mark.

Take the latest news on June industrial production and housing starts. Industrial output fell 0.3% last month, after gains averaging 0.6% per month during the first five months of 2004. But reports on industrial activity in June and early July coming from the nation's purchasing managers and regional surveys have remained robust.

The stronger reports support the idea that production will rebound because many businesses still need to build up their inventories to meet demand. In May, the ratio of all business inventories to sales, a measure of the adequacy of stock levels, remained at a record low of 1.3, which is far below its long-term trend. Pressure to increase inventories will support future production gains.

In addition, June's 8.5% drop in housing starts, the largest fall in more than a year, also looks flukey. Mortgage rates have come back down in early July, and mortgage applications remain at a high level. Moreover, the July survey from the National Association of Home Builders shows that construction activity is solid.

ON THE INFLATION FRONT, Greenspan's belief that most of the price pressures in the first half will prove to be transitory appeared to gain support from the June consumer price index. Much of the acceleration in the price indexes this year has been fueled by rapidly rising energy prices. But the underlying trend in inflation, outside of fuel and food, is much tamer. Indeed, the core CPI, which excludes those two volatile items, rose just 0.1% in June from May, the smallest increase this year.

Two Price Measures, Both Moving Higher
Watching the CPI to decipher the Fed's intentions, however, may be a bad game plan. The Fed now looks at the core price index for personal consumption expenditures, which excludes energy and food. The Fed switched its focus from the overall PCE index to the core PCE index because it said the core reading "is better as an indicator of underlying inflation trends" than the overall index. That means the Fed is more concerned with long-run patterns than with the short-term gyrations that energy and food can cause.

Under the core PCE index, inflation is running at only 1.6% over the past year, up from 1.3% this time last year. By contrast, the CPI puts core inflation at a higher 1.9%, up from 1.5% a year ago. No matter what core index you pick, the underlying pace is moving up.

The more critical point for the outlook, however, is that by any measure, inflation is far from exhibiting the unruly behavior that would knock the Fed off its measured pace of tightening. The only way that could happen is if the economy turns out to be a lot stronger than the Fed now expects.

By James C. Cooper & Kathleen Madigan

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