The Fed: Now the Navigating Gets Really Tough

Even as Americans long for signs of recovery, booming emerging markets and global inflation are heightening pressure to raise interest rates

The Federal Reserve's efforts to balance growth and inflation are reaching a critical juncture. The worst fears about U.S. economic growth in 2008 are subsiding. The financial markets are still fragile but functioning better, and chances of a serious recession, or any recession, are diminishing. Now the Fed is setting its sights on inflation, which could play a big role in the outlook for growth in 2009. Lifting interest rates later this year to fight inflation would risk extending the housing slump and the credit crunch, and it would lessen the chances for a solid recovery.

How much growth the Fed is willing to sacrifice next year by raising rates will depend on the seriousness of the inflation threat. Economists are sharply divided over whether the Fed will—or even should—lift rates to keep prices down. Many believe the weak economy will prevent soaring energy and food costs from fueling inflation more broadly. Historically, recessions kill inflation because they hammer the job markets, depressing demand and keeping higher wages from pushing up prices in an upward spiral.

Others aren't so sure, and for good reason. This is not your ordinary inflation threat because globalization may have changed the rules. This time the pressures are coming from outside the U.S. The push is not only from oil, but also from a variety of commodities and other imports, and it is unlikely to subside soon. Plus, rapidly growing markets for U.S. exports are supporting domestic growth and limiting the inflation-dampening effects of the national slowdown. It's unclear whether the current period of weakness is sufficient to hold down the wage-price spiral.

Global inflation has already hit a nine-year high of 4% annually, and it will rise further as the latest jump in oil prices works its way through world markets. The problem stems partly from past ultra-easy monetary policies: Global central bank rates have been exceptionally low since 2002. Central bankers have not been this accomodative for so long a time since the 1970s.

That's especially true in emerging-market economies, which now account for half of world gross domestic product and provide a market for half of U.S. exports. While the inflation fighters at the Fed and the European Central Bank are preparing for battle, developing nations are still partying, with few signs that their monetary authorities are ready to take away the punch bowl. Growth in emerging markets, fueled by booming domestic demand in China and hot Asian economies, is zipping along at about 7%, with overall inflation running at more than 7%. With tight labor markets in these nations driving up wages, core inflation (which excludes energy and food) has also accelerated, indicating a broad and worsening problem.

The resulting surge in global commodity demand and prices is already showing up in higher wholesale prices for many U.S.-made goods, especially in the earlier stages of processing, and even excluding energy and food. In particular, core wholesale inflation for finished goods rose to 3%—double the rate at this time last year, and the highest figure since 1991. There is still almost no evidence that these cost pressures are creeping into retail prices. Yet the close correlation between the prices of consumer goods leaving the factory and those in the shops suggests that retail inflation is due to pick up.

Inflation abroad is also pressuring U.S. prices via the weaker dollar and import prices. Imports now make up about 16% of America's domestic demand, double their importance in the early 1990s. Excluding petroleum, import inflation is running at 6.6% in May, the highest since records began in 1990. Imported raw materials aren't the only culprit. Prices of imported autos are up 3.1%, and those for all other consumer goods are up 3.6%, the fastest increases in more than a decade.

Given these growing pressures, keeping inflation under wraps in 2009 may require an extended period of weak growth. If the credit crunch and the housing slump don't deliver it, the Fed may have to. Either way, a strong recovery seems unlikely next year.

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