Fed Urged to Shift Stance on Deflation

Pressure is growing on the Federal Reserve to make clear that it’s ready to fight inflationary forces in the economy -- and to stop talking about deflation.

The central bank, which for more than a year has held its key short-term interest rate at generational lows to help the nation’s recovery get up a head of steam, is facing a torrent of data suggesting that it might have kept credit too easy for too long.

On Wednesday, the government reported that the consumer price index jumped 0.5% in March, well above the 0.3% rise most economists had expected.

The so-called core rate of inflation, excluding food and energy costs, rose 0.4% last month, the biggest increase since November 2001.

And the inflation news followed a government report on Tuesday that retail sales surged 1.8% in March, indicating that consumer spending remains robust.

Other reports in recent weeks also have pointed to an economy that is accelerating.

That’s what the Fed has wanted, of course. But with the goal apparently reached, many analysts believe the central bank must signal that it is poised to begin tightening credit to make sure that the economy doesn’t overheat, and that inflation doesn’t surge.

“The real risk now is that they will wait too long” to raise rates, said Michael Darda, economist at investment firm MKM Partners in Greenwich, Conn.

On Wall Street, many analysts had been expecting the economy to slow and the Fed to hold off on rate increases until 2005. But that view is rapidly changing.

Brokerage Lehman Bros. on Wednesday altered its forecast, predicting the Fed would raise its key rate from the current 1% to 1.25% in September instead of waiting until next year.

A Reuters survey of 21 major bond dealers on Wednesday found that seven now expect the Fed to begin boosting rates by August.

Few, if any, analysts believe the Fed will take any action before June. The assumption is that Chairman Alan Greenspan and other Fed members want to make sure that the economy can sustain the recent pickup in job growth.

What’s more, many Fed officials have emphasized that they believe there is significant “slack” in the global economy -- meaning a surplus of labor and excess production capacity -- that should limit the risk of inflation accelerating.

Nonetheless, some experts say Greenspan and cohorts must show sooner than June that they won’t allow inflationary pressures to keep building.

Joel Naroff, head of Naroff Economic Advisors in Holland, Pa., said the Fed could start at its May 4 meeting by removing the language it has been using for some time in its official meeting statements, referring to deflation risks.

After its March 16 meeting, the Fed used its usual code in discussing deflation, saying that “the probability of an unwelcome fall in inflation has diminished in recent months.”

The Fed began to warn a year ago that it was worried the economy was vulnerable to the kind of broad-based price declines, or deflation, that ravaged Japan in the 1990s.

Even if the risks were significant a year ago, they aren’t now, Naroff said. Consumers and businesses are facing higher prices nearly across the board, including for homes, energy, food and other commodities, medical care, education and insurance.

“They continued that [deflation] fiction into the last statement. If it’s not out of the next statement it will be laughed out” by investors, he said.

If the Fed continues to warn about deflation in an economy that is growing at a brisk pace, the risk is that investors could begin to fear that the central bank has lost its willingness to keep inflation contained, analysts say.

For owners of fixed-income securities such as bonds, inflation is the biggest threat they face over time. If investors begin to believe that inflation might rise from last year’s pace of about 2% (as measured by the consumer price index) to, say, 4% by 2006, they would be likely to demand far higher yields on bonds to compensate.

Bond yields already have been rising in recent weeks, but at 4.36% on Wednesday the yield on the 10-year Treasury note still is below last year’s peak of 4.6% reached in September. And it’s well below the 6%-plus levels of 2000.

If the Fed wants to avoid the risk of bond investors overreacting and driving long-term yields excessively high -- which could bring about another recession -- it must begin to raise short-term rates sooner rather than later, Darda said. He thinks the Fed will raise its key rate a quarter point in June.

The issue is one of relatively moderate pain for the economy in short run if the Fed begins to tighten credit in a matter of months, or potentially much worse pain later if they wait, many experts say.

Drew Matus, economist at Lehman, said the tone of some Fed members’ speeches recently was that the central bank’s inflation-fighting credentials are impeccable.

“They’re saying, ‘Trust us,’ ” Matus said. “But it’s unclear whether the markets are going to trust them.”

At the Fed, actions now are likely to speak louder than words, economists say.