Prices pose dilemma for Fed
An ominous scenario of rising prices and slowing growth showed itself in spades Wednesday as the government reported that consumer prices are rising at a fast pace even as the housing sector remains stuck in its worst slump in a quarter-century.
The combination of inflation and faltering growth -- the infamous “stagflation” of the 1970s -- creates a potential double bind for economic policymakers: Fight one and risk feeding the other.
To the amazement of many analysts, however, the Federal Reserve, under Chairman Ben S. Bernanke, signaled that it had already decided how it would address that dilemma. The plan is to tackle the slowdown through continued interest rate cuts while accepting the risk of higher prices.
In the minutes of its late-January meetings and several conference calls released Wednesday, central bank officials made it clear that they would go for growth.
“In 2007, they were balancing their two objectives of price stability and sustainable economic growth,” said Vincent Reinhart, former director of the Fed’s division of monetary affairs. But now, “they care about growth first. They’re going to take a chance with inflation, and if you look at their projections, they think they can get away with it.”
The danger is that prices will get out of hand as they did in the 1970s and as they hinted at doing again in the report of January inflation.
The 0.4% increase in the overall consumer price index reported for last month was higher than analysts had expected. But in the latest report, it was striking that the increases were not limited to the usual suspects, food and energy. Instead, they also involved categories that had fallen or remained stable previously -- and thus had helped offset the recurrent food and energy increases.
Computer prices, for example, which had tumbled 12% over the last year, climbed 1% last month, according to Stephen G. Cecchetti, former research director of the New York Federal Reserve Bank. And restaurant meals, which had been stable, rose at a 4.9% annual rate, he said.
In January, “you have to look with a microscope to find falling prices. At the level of detail normally reported . . . more than three-quarters of prices rose,” said Cecchetti, now an economist with Brandeis University.
The price index’s 12-month change through January was 4.3%. By contrast, the index’s annualized rate of change stayed mostly between 2% and 3.5% from 2002 through 2006 -- even as the economy picked up speed.
The biggest increase in the January inflation report was fuel (up at a 54.7% annual rate during the month), and oil prices have continued to climb, reaching a record $100 a barrel this week.
“I think oil has a shot at hitting $150 a barrel before the end of the year,” said Peter Schiff, chief executive of Euro Pacific Capital, a Connecticut brokerage house. “This is a highly inflationary period, and we’re creating the inflation.”
Over the last month, Fed leaders have repeatedly signaled that their long-standing concern about inflation was giving way to worry about growth, housing and frozen credit markets. In January, the Fed’s policymaking Federal Open Market Committee made some of the steepest interest rate cuts in its history.
But until Wednesday, the Fed had not come right out and said it thought rates would have to be held “relatively low” for an extended period, as the newly released minutes do. Nor had it acknowledged that the low rates would mean higher inflation, as the forecasts included in the minutes effectively do.
“Several participants noted that the risks of a downturn in the economy were significant,” said the minutes of the Fed’s conference calls Jan. 9 and Jan. 21 and the Jan. 29-30 meeting. “Many participants were concerned that the drop in equity prices, coupled with the ongoing decline in house prices, implied reductions in household wealth that would likely damp consumer spending.”
According to the minutes, some members of the committee said that when the economy had improved, “a reversal of a portion of the recent easing actions, possibly even a rapid reversal might be appropriate.”
Still, policymakers suggested that their interest rate cuts are not feeding inflation because the economy is so weak there’s no pressure to push up prices. Their position was hard to square with the latest report, showing an accelerating CPI.
The depth of the economic quandary and the risk confronting Fed policymakers as they pursue their strategy are clearest when contrasted with the approach of other central banks around the globe. Most put a single goal above all others -- price stability.
“The Fed is inverting that,” Reinhart said. “They’re putting growth first.”
Although the mood of the Fed’s January meetings was far from alarmist, a revised economic forecast included in the minutes noted that growth would be lower, and inflation and unemployment higher, than policymakers had predicted as recently as October.
The Fed portrayed the economy as coming close to a stall this year. They forecast that gross domestic product would expand only 1.3% to 2% before recovering in the following two years. In the fall, they forecast growth for 2008 between 1.8% and 2.5%.
GDP expanded at only a 0.6% rate in the final three months of last year, matching its slowest pace in five years.
Supporting the Fed’s slow-growth outlook, the Commerce Department said Wednesday that housing construction puttered along at a 1.012-million-unit rate in January.
The 1-million-unit pace was less than half the 2.3-million rate at which houses were going up in early 2006, at the peak of the boom. Analysts said that it would leave the real estate industry mired in its deepest recession in decades.
The housing slump is widely seen to be dragging down the economy as a whole, slamming the construction industry and shrinking household wealth.
Fed policymakers predicted that anemic growth would nudge up the unemployment rate from its current 5% to between 5.2% and 5.3% this year, up from their previous prediction of 4.8% to 4.9%.
Most strikingly, they forecast that the combination of their own growth-spurring interest rate cuts and other economic forces would cause prices to rise between 2.1% and 2.4%, higher than their previous prediction of 1.8% to 2.1%, and higher too than their “comfort zone” of 2%.
Within the CPI, the so-called core inflation rate -- excluding food and energy -- was up 2.5% for the 12 months ended Jan. 31.
In some ways, inflation is fed by people’s expectations about whether prices will keep rising and thus can be a self-fulfilling prophecy. As a result, Fed officials have talked about how their ability to continue cutting rates or melt a financial freeze depends on inflation expectations staying where they are.
But many veteran Fed watchers wondered aloud Wednesday how long expectations can stay anchored when the central bank has clearly come out in favor of growth over containing inflation, especially if data continue to resemble those issued Wednesday.
“Policymakers always say things will stay in place or they can change policy fast enough if they don’t,” groused Allan H. Meltzer, a Carnegie Mellon economist who is writing a history of the central bank.
“But when the time comes, things don’t stay in place or people don’t make the change,” he said.
The current Fed, he said, “is repeating the mistakes of the 1970s.”
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Stagflation
“Stagflation” is the combination of economic stagnation and inflation. For years, economists thought the condition was a logical impossibility. If an economy stagnated -- slowing down or actually shrinking -- that would reduce demand and push prices down, not up.
But, impossible or not, stagflation occurred during the 1970s and early 1980s as the economy fell into repeated recessions even as prices climbed. Between November 1973 and March 1975, the gross domestic product shrank in real, after-inflation terms by 2%, but prices as measured by the consumer price index still rose almost 15%.
