The Inflation Debate Grows Louder

The Fed appears to be done with aggressive rate-cutting. Now the question is whether the weak economy will keep prices in check

After weeks of signaling a preference for sharp cuts in interest rates, Wall Street is sending the Federal Reserve a new message: It's O.K. to be a little less aggressive now. Based on futures contracts as of Apr. 23, the probability of only a quarter-point reduction in the Fed's target rate, to 2%, at its Apr. 30 meeting was 84%, with no chance of a half-point move and even a few bets for no change. Since the Bear Stearns (BSC) crisis, stock prices have rallied 8%. Yields on super-safe Treasury securities have risen, and various benchmark credit spreads have narrowed somewhat, all indicating that investors are increasingly willing to come out of their bunkers and take on a little more risk.

Coming after three interest rate cuts, totaling two percentage points in only eight weeks—for a total of three points since September—a return to gradualism at the Fed would be a milestone. It would suggest the Fed's work for this policy cycle is winding down. And some analysts and policymakers believe the moment is near when the Fed can shift its policy priorities from shoring up a frail economy to assuring inflation stays under control.

Inflation: Lessons from History?

Even within the Fed, policymakers have voiced concern about the U.S. inflating its way out of its problems. Dallas Fed President Richard Fisher, one of two policymakers who dissented from the size of the Fed's Mar. 18 rate cut, indicated on Apr. 17 his "very strong reluctance" to further easing. Nasty-looking March price indexes, a relentless rise in commodity prices, and the swooning dollar's upward push on import prices only fuel the growing inflation debate.

The March consumer price index was reassuring only if you believe soaring energy and food costs will not seep into other prices. For the quarter, the consumer price index rose 4.2% from a year ago, almost double its rate this time last year, but the core index, which excludes energy and food, was up only 2.4%, slightly below its year-earlier clip. However, the acceleration in wholesale prices suggests growing pressure in the pipeline. The core producer price index for consumer goods in March climbed 3.3% from a year ago, the fastest annual rise in nine years.

Most Fed officials are betting the weak economy will trump inflation. History is on their side: Inflation has always cooled after a recession, as pricing power ebbs and wage gains slow. If people expect low inflation, prices and wages will not spiral up together. Higher costs will squeeze profit margins, not boost prices. Wages are already slowing, and measures of inflation expectations remain tame. In this environment—so goes the argument—overall inflation, driven by pricier food and energy, will end up pushing core inflation lower as those costlier necessities cut into the purchasing power of incomes and reduce demand for other discretionary items.

Inflation hawks, however, worry that history may be less relevant this time, partly because the global economy is now more inflationary. Economists at Barclays Capital say soaring commodity prices partly reflect ultra-easy monetary policy. They calculate that global central-bank rates have been exceptionally low for five years and represent a level of policy ease not seen for that long since the 1970s. World inflation as measured by JPMorgan Chase (JPM) hit a nine-year high in March.

High Commodity Prices

The global economy is also more interlinked and somewhat less sensitive to U.S. growth. America's slowdown has resulted in a sharply lower dollar that is boosting import prices, even outside of energy products, but it has done nothing to cool off global commodity prices. Rising overseas inflation may soon pressure other central banks to raise interest rates, which would add to the downward pressure on the dollar, further muddying the U.S. inflation outlook and complicating the Fed's policy decisions.

The optimal outlook for Wall Street and the Fed would be steady healing of the credit markets, nothing worse than a mild recession, and signs that inflation pressures are easing. Right now, it looks like inflation could be the trickiest part of that scenario.

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