The New Republic

So far this year, inflation has clocked in at an eyebrow-raising 5
percent annual rate. But that didn't stop the Senate Banking
Committee from giving the nation's chief inflation fighter, Federal
Reserve Chairman Alan Greenspan, the kid-gloves treatment during
his reconfirmation hearing two weeks ago. Senators of both parties
fell over themselves to praise Greenspan's "cool head and keen
understanding of the markets" (Liddy Dole) and "your integrity,
your intelligence, your ability to balance prosperity and inflation,
a very difficult thing to do" (Chuck Schumer). John Sununu went so
far as to suggest that the maestro might soon have to decide which
unit of currency his portrait should grace.To the extent that Greenspan had to discuss inflation, it was only
in passing. "[O]ur general view is that inflationary pressures are
not likely to be a serious concern in the period ahead," he told
the committee in response to a question from Chairman Richard
Shelby. The senators either nodded attentively or failed to absorb
the statement (or both), and the topic went more or less unexplored
for the subsequent two hours.

But the Fed's confidence in its inflation outlook--and the Senate's
blithe unconcern--are misguided at best. The prevailing view at the
Fed, as Greenspan put it in congressional testimony earlier this
spring, emphasizes the concept of "slack." Since the economy hasn't
grown as quickly as it could in recent years, the argument goes,
there should be plenty of unused resources available. That means
businesses should be able to increase output without seeing the
costs of their inputs rise, costs they'd eventually have to pass
along to consumers. Fair enough. The problem is that, in practice,
slack is almost impossible to measure. Meanwhile, easier-to-measure
indicators popular on Wall Street--not least the inflation rate
itself--all point to a steady rise in prices. If Greenspan is
wrong, and the financial markets are right, the only way the Fed
will be able to get inflation back under control is by raising
interest rates quickly and steeply--the classic way to trigger a
recession.

The concept of slack has a rather notorious pedigree at the Fed.
Throughout the 1950s and 1960s, legendary Fed Chairman William
McChesney Martin deemphasized precise measurements of economic
variables in his approach to setting interest rates. Martin's
reasons for doing so were more epistemological than ideological: He
didn't reject the relationship between slack and inflation; he was
just skeptical of economists' ability to gauge it. "[Martin] felt
that the economy was too complex to explain in detail; intuition
would be lost and false leads followed if too much stress were put
on measurement," former Fed Governor Sherman Maisel, who served
under Martin, wrote in his book Managing the Dollar.

But things changed radically in 1970, when Arthur Burns, one of the
country's foremost business-cycle economists, succeeded Martin as
chairman. Burns felt that the amount of slack in the economy could
be accurately measured. During Martin's last year at the Fed,
reports of rapid economic growth and rising inflation had led him
to hike interest rates. But, after conducting his own
investigation, Burns concluded there was considerable slack in the
economy and argued vigorously for a rate cut. The cuts persisted
even as inflation continued to rise, heralding a disastrous period
of rising prices that plagued the economy for more than a decade.

We now know that Burns's measures of slack were simply wrong. Burns,
according to a 2000 paper by Fed economist Athanasios Orphanides,
believed the unemployment rate could fall to 4 percent, where it
had stood for much of the '60s, without triggering inflation. What
Burns didn't realize was that the underlying structure of the
economy had changed--the large productivity gains the country had
experienced during the previous decade were coming to an end;
demographic changes were altering the labor force. As a result, the
economy was already producing as much as it could when Burns began
cutting interest rates.

To be fair, today's Fed is less arrogant and more agile than it was
in Burns's day. "They don't sit there and say, 'The output gap is
1.254 percent. .. . That's what we know, stick with it,'" says
Laurence Meyer, a Fed governor during the late '90s. Instead,
according to Meyer, the Greenspan Fed is constantly comparing its
forecasts to fresh data and adjusting its models accordingly.

Still, for all its supposed humility, the Greenspan Fed places an
awful lot of faith in measures that aren't much more knowable than
they were during the '60s. Take, for example, the output gap, which
is the difference between what the economy can produce and what it
is actually producing. The size of the output gap ultimately hinges
on productivity growth. If productivity were to continue increasing
at today's remarkably rapid rate--roughly 4.5 percent over the last
few years--then the economy could grow faster than 5 percent over
the long term (the rate of productivity growth plus 1 percent labor
force growth). Alas, almost no one expects this to happen. Even
worse, as Lehman Brothers chief economist Ethan Harris points out,
neither does anyone know when productivity growth will taper off
(it may have already), or by how much. Yet, the Fed is unmoved. Fed
Governor Ben Bernanke, speaking in April, cited high productivity
growth as a factor that "will help keep inflation under control for
the next couple of years."

Another measure of slack is how much of the country's productive
capacity-- factories, equipment, et cetera--is currently in use. If
the answer is not much, businesses can easily ramp up production in
response to rising demand for their products. If the answer is a
lot, then businesses will simply raise prices. (In the long run, of
course, they can build more factories and buy more equipment.) The
Fed's measure of capacity utilization in the manufacturing sector
weighed in at 76.4 percent in May, suggesting the former scenario.
By contrast, the Institute for Supply Management (ISM), a private
manufacturing research group, estimates the figure to be over 85
percent. That's a critical difference, since economists believe
prices start rising when utilization rates exceed 80 percent.
Unfortunately, flaws in the Fed's capacity-utilization methodology
mean the ISM number is probably closer to the truth. "We're finding
out that [the Fed's measure] is woefully low, that it contains
facilities that are already mothballed," says Jim Paulsen, an
economist at Wells Fargo Capital Management in Minnesota.

All of which might be forgivable sources of confusion--except that
so many other indicators suggest inflation is a problem. The most
obvious cause for alarm is the core consumer price index (CPI),
which excludes volatile food and energy prices. Core CPI has
increased by 1.8 percent since May of last year and at a 2.9
percent annual rate during the first five months of this year,
putting it above the Fed's unofficial comfort zone of 1 percent to
2 percent. The Fed discounts the recent numbers as a blip rather
than a long-term trend. But a variety of other factors suggest the
opposite. First, it's not just consumer prices. Producer prices are
increasing rapidly--5 percent over the last year (and nearly 2
percent excluding food and oil). Likewise, the weak dollar and
recent inflation among major trading partners have nudged import
prices up as well.

Perhaps more important, as The Economist recently pointed out,
inflation expectations are rising. In May, the University of
Michigan Survey of Consumers put median one-year inflation
expectations at 3.3 percent, a nine-year high. Another important
measure of inflation expectations, the spread between the yield on
regular long-term Treasury bonds and inflation-protected Treasury
bonds, known as tips, recently hit a seven-year high. Expectations
of inflation can create actual inflation, since businesses tend to
raise prices and workers tend to demand higher wages when they
anticipate their own expenses rising.

But, even if you reject all this, the Fed's reluctance to raise
interest rates more rapidly is confounding. (The Fed has hinted it
will raise rates by only a quarter-point this week.) The whole idea
behind moving the federal funds rate from 1.75 to 1 percent between
November 2002 and June 2003 was to take out an "insurance policy"
against Iraq-related uncertainty and deflation (commonly defined as
generally falling prices), which Fed officials were convinced was a
small, but serious, risk. Or, put differently, the Fed lowered
short-term interest rates last year in a deliberate attempt to
create inflation. Now that even the Fed admits the risk of
deflation has passed, it makes no sense to keep that policy in
place.

Fed officials argue that they can always raise interest rates later
if they turn out to be wrong. But inflation tends to be
inertial--making it tough to kill once it takes root. What's more,
according to most economists, interest rate movements take more
than a year to work their way through the economy. Given the Fed's
current go-slow approach, Brandeis University economist Steve
Cecchetti, a former research director at the New York Fed, wrote in
his recent "Inflation Update," "inflation will continue to rise for
the next 3 years!" Economists like Cecchetti and Diane Swonk, of
Bank One in Chicago, believe that inflation could rise above 3
percent by 2007. "I think, at that point, [the question is] how
high do rates have to go" to get inflation back in check, says
Swonk. Most economists agree that, if inflation resurfaces, it will
take rates of at least 6 or 7 percent to rein it in. And that, says
Swonk, could trigger a recession. Maybe we shouldn't get that
Greenspan greenback ready just yet.

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