Inflation mentality on Fed’s mind
The stories this week about people hoarding rice at some big-box U.S. retailers had to send at least a slight chill up the spines of Federal Reserve policymakers.
You think we’ve got an inflation problem now, given what you’re paying for groceries and gasoline? It could be far worse if millions of people start to believe that prices in general are on the verge of going sharply higher.
That’s when inflation becomes self-fulfilling: “I need to stock up on X, because X will cost a lot more tomorrow.” By buying more of X than you need, you can drive up its market price. Voila! You create the problem that you foresaw.
For those who are old enough to remember, that’s what began to unfold in the 1970s. As inflation worsened, in part because of the first surge in oil prices in 1973, many consumers were gripped by fear of ever-rising prices.
It took double-digit interest rates -- and the painful back-to-back recessions of 1980 and 1981-82 -- to finally break the inflation monster’s back.
The run on rice, isolated an incident as it may be for now, helps set the scene for the Fed’s meeting Tuesday and Wednesday. And it gives Chairman Ben S. Bernanke and his peers one more reason to signal that they’d prefer not to cut short-term interest rates much further for fear of aggravating inflation pressures.
The Fed may have floated a trial balloon to that effect Thursday, when a front-page story in the Wall Street Journal said central bank officials were likely to trim their benchmark rate to 2% from 2.25% next week but also were mulling over whether to pause after that.
If it was a trial balloon, the Fed had to be happy with the results. The stock market rallied Thursday, the dollar rose and commodity prices fell.
On Friday, stocks and the dollar again gained ground, though commodities rebounded, led by oil as tensions rose between the U.S. and Iran.
What do short-term interest rates have to do with inflation? It’s convoluted, but many people know the basics. If credit is too easy and money floods the economy, it can result in the textbook inflationary scenario of “too much money chasing too few goods.”
Credit obviously was too easy in the housing market from 2002 to 2006, which gave us the housing boom that has since gone bust.
This time around, credit remains tight even though the Fed has slashed interest rates. But low rates are feeding inflation concerns in other ways.
One is by weakening the dollar. Low U.S. interest rates, particularly compared with European rates, mean some global investors are avoiding U.S. fixed-income securities in favor of higher-yielding foreign issues. The lower U.S. rates go, the less attractive U.S. bonds become, which boosts the value of foreign currencies and undercuts the dollar.
A weak greenback is great for U.S. exporters because it reduces the prices of their products for foreign buyers. But the flip side is that a cheapened dollar can drive up prices of imports as Americans’ purchasing power wanes. That’s inflationary.
What’s more, as the dollar tumbled in recent years it egged on the bull market in raw materials. Here’s why: Commodities generally are priced in dollars on world markets. So as the buck weakens, commodity exporters get less for their stuff -- unless they raise prices.
There’s a lot more behind the surge in commodities than the dollar’s slump, of course. In the case of many raw materials, including oil, demand has been robust worldwide and supplies haven’t kept up. But a weak U.S. currency adds impetus to commodity price increases, such as by encouraging investors and speculators to bet on those markets as a hedge against the anemic dollar and inflation in general.
The Fed, therefore, has every reason to try to show that it’s serious about corralling inflation pressures. And it could do that, at least for the moment, by hinting that it’s finished cutting interest rates.
Wall Street connects the dots this way: The Fed stops lowering rates, which tells speculators to stop pushing down the dollar, which in turn undercuts a key support for rising commodity prices. If that helps pull oil down from its current lofty heights, consumers would feel better, which could damp fears of a deep U.S. recession, which could lift the stock market.
There are other reasons the Fed may feel justified in pausing after next week’s expected cut. One is that strapped consumers will be getting help in the form of the government’s tax rebate checks, which will land in mailboxes in May.
David Wyss, chief economist at Standard & Poor’s in New York, figures the Fed will trim its key rate to 2%, “then go on hold to see what happens with the rebate checks” -- meaning, whether people spend the money, save it or use it to pay off debt.
Bernanke and crew also can take comfort in what’s happened in the Treasury-bond market since the Fed took unprecedented steps in mid-March to shore up the finances of struggling banks and brokerages. Investors, fearing a financial-system crash, had rushed into Treasury securities for their perceived safety, driving yields to extreme lows.
In recent weeks, as investors’ confidence has improved they have been selling Treasuries in favor of riskier securities, such as stocks and junk bonds. That switch has driven up Treasury yields, but it’s a good thing because it indicates that investors no longer feel Armageddon is around the corner.
To be sure, many people believe the worst is yet to come for the economy (note the latest survey on consumer confidence) and that the Fed will have no choice but to cut interest rates further.
But for now, the central bank is in good position to at least foster the perception that it won’t let an inflation mentality take hold -- and to hope perception becomes reality.
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