The Fed: Time for Tough Love?

The dollar is sinking. Inflation is on the rise. Should Bernanke & Co. take a page from the Paul Volcker playbook and start raising rates?

by Chris Farrell

On Mar. 7, when the government reported a loss of 63,000 nonfarm jobs in February (with a decline of 101,000 private-sector jobs), it seemed that both Wall Street and Main Street decided all at once that, yes, the U.S. economy is in recession, or well on its way into one. That's why there's little doubt among the financial cognoscenti that when Federal Reserve policymakers meet on Mar. 18 the central bank will cut its benchmark interest rate again, perhaps by half a percentage point, to 2.5%.

If so, the Fed will have slashed its target rate by 2.75% since last August. But while the central bank's concerted policy of monetary easing is aimed squarely at forestalling a recession and lending a hand to the shaken financial system, other dangers lurk.

Inflation as Bailout

Here's the rub: While the Fed fights recessionary forces, inflation is gathering momentum. "It's the 'Fed to the rescue,'" says Jonathan Guyton, certified financial planner at Cornerstone Wealth Advisors in Edina, Minn. "But I'm worried that their actions will set up a real inflation problem a year from now."

Maybe sooner. The headline consumer price index and producer price index figures are already running at rates double to quadruple above the Fed's target range for inflation. The dollar has plunged to a record low against the euro, to a 12-year low against the Japanese yen, and is now nearly at par with the Swiss franc. After adjusting for inflation and trade flows, the dollar is off some 20% since peaking in early 2002, according to Mark Zandi, chief economist at Moody's Economy.com (MCO). The rise in the cost of imports spurred by the decline in the dollar is putting upward pressure on U.S. prices.

And the ripples are being felt in other markets as well. Gold, the hoary "currency" hedge against inflation, is trading around $1,000 an ounce. Oil, wheat, and other commodities are skyrocketing.

"So far I think all the tea leaves point to inflation as the bailout: thus, the run in oil, gold, and nondollar currencies all makes some sense," writes Bernard Picchi, a veteran oil industry analyst with Wall Street Access. "Very scary nonetheless."

A 1970s "Malaise"

The dollar's decline echoes some frightening moments in the recent past. In Secrets of the Temple, William Greider's magisterial history of the Fed, he recounts how global investors reacted to President Jimmy Carter's attempt to address inflation with his "malaise" speech on July 14, 1979. "The American dollar, bought and sold daily in huge volumes on the currency exchange, had been sliding in value, almost every day. This meant currency traders—banks, multinational corporations, wealthy investors, perhaps even other governments—expected the U.S. dollar to continue to lose its value in the coming weeks and months, and they, therefore, found it safer to hold their wealth in other currencies," writes Greider. "Roughly translated, the dollar's steady decline amounted to an inflation forecast."

Back in the days of disco, the opinion of the international financial community was that American inflation would get worse—a judgment that proved right. Shades of today's wobbly dollar?