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News: Analysis & Commentary
Split Vision: Is This Inflation Different?
Fed vs. Fed over whether the New Economy permits a smaller rate hike
Federal Reserve Chairman Alan Greenspan likes to compare the central bank to a sailor docking a boat. If the boat comes in too fast, he says, it could crash into the dock and burst into smithereens.
Right now, a lot of people are fretting about that just that scenario. They fear that the Fed hasn't been aggressive enough in slowing the economy, with five quarter-point increases in short-term rates in the past 10 months. And they argue that the Fed went too far in easing financial conditions in 1999 to cope with the millennium computer glitch. "Last year, I didn't think we should shoot inflation while it was trying to surrender," Federal Reserve Bank of Dallas President Robert D. McTeer Jr. told economists in Washington on May 1. "But more recently, it has been showing signs of resisting arrest."
The worriers see plenty of evidence of overheating: Consumer spending, which accounts for two-thirds of U.S. economic activity, grew at an 8.3% annual rate in the first quarter, its biggest rise in 17 years. New-home sales jumped 4.5% in March to their highest level in 16 months. And in the first quarter, sharply higher costs in benefits sent the Employment Cost Index soaring at an annual rate of 4.3% (page 44). Add it all up, and the Fed's biggest bugaboo, inflation, is baaaack: In March, the consumer price index rose 0.7%, bringing the annual rate for the first quarter to 5.8%.
Fed insiders say that has led to an intense debate about whether to get tough and raise rates by a half-percentage point, instead of a quarter point, at its next meeting on May 16. And with the release on May 3 of the Fed's latest survey on regional economic conditions--which showed no slowdown in sight--fears of a half-point rise hit the stock market hard. The Nasdaq Composite Index, the Standard & Poor's 500-stock index, and the Dow Jones Industrial Average each lost more than 2%.NEW ERA GROWTH. The debate about how much to raise rates boils down to whether the latest bout of inflation is different from previous episodes. Traditionalists say it's not: Inflation is inflation. But believers in the New Economy insist that today, productivity-enhancing technology creates downward price pressure. This, in turn, relieves some of the need for drastic measures to control inflation by cooling the economy. "New Era growth is underpinned by strong high-tech capital spending, resulting in accelerating productivity," says ex-Fed Governor Wayne Angell, chief economist for Bear, Stearns & Co.
The debate probably won't be resolved until policymakers meet May 16, insiders say. Much will depend on economic data such as the April jobless data on May 5 and the April consumer price report on May 16.
Who's right? For starters, it's important to note that today's inflation comes against a backdrop of long-term price stability. Goldman, Sachs & Co. equity strategist Abby Joseph Cohen observes that in the 1960s and 1970s, inflation was deeply embedded in the economy. Prices rose because of stimulative deficit spending, loose money, the Vietnam War, rising oil prices, and public acceptance. "If everyone is expecting inflation to be rising, there's not much resistance to it," she says.
That's not the case today. Many of the inflationary forces of that era are gone. Even oil prices, which played a big role in the April leap in consumer prices, have receded. Easy money is another inflation-boosting factor that is losing its punch. It's true that the Fed slashed rates by a quarter point three times in late 1998 to cope with the global financial crisis. That stoked growth and inflation. But the Fed has taken back those cuts and more.
The easy money connected with the Y2K software crisis is gone as well. In the last quarter of 1999, the monetary base grew $40 billion in anticipation of a Y2K run on money. Some economists blame the surge for the economy's overheating in the first quarter. But the Fed learned something from its experience in 1987, when liquidity that it added after the stock market crash led to inflation. This time around, the Fed moved more aggressively to sop up excess liquidity, shrinking the monetary base by $21 billion in the first quarter. "The Fed put in too much money last year.... This year they have righted that wrong," says Lawrence Kudlow, chief economist of Schroder & Co. in New York.
Still, inflation hawks point to a range of indicators that inflation is getting out of hand. On May 3, the Fed's survey of economic conditions cited "more frequent reports of intensifying wage pressures as shortages of workers persisted in all Districts." The survey, known as the Beige Book, said: "Employment costs remained under pressure and appeared to intensify in the last two months." Indeed, with the tightest job market in 30 years, first-quarter labor costs for U.S. businesses climbed at their fastest pace in more than 10 years.
And despite Cohen's calming words, inflationary psychology may be creeping back. Household expectations of inflation have climbed by a percentage point since early 1999, to 3.6%, a University of Michigan survey says. "It's eliminating any margin for error by the Fed," says Louis B. Crandall, chief economist at economic consultants R.H. Wrightson & Associates.POWERFUL. The good news? Technology is far more of a force for price stability than it ever has been. Yes, wages are rising, but so is worker productivity, which grew about 3.5% in the past year. As long as workers earn their higher pay by producing more, inflation pressure is eased. And the best evidence that they're earning their pay is that corporate profits continue to skyrocket (page 108).
Moreover, for all the short-term inflationary pressures, longer term the Internet is a hugely powerful disinflationary force. A new study produced by Goldman's London-based economic staff concludes that procurement over the Net should enable U.S. output to rise by 5% over what it would have been over the next decade--without sparking inflation. To take just one example, General Motors Corp. says that buying online should cut the cost of handling purchase orders from a little over $100 to the low single digits. That, says GM, should save about $1,400 per car. The Net also caps labor costs by making it easier to ship work abroad. "While labor is tight in this country, it is not equally tight around the world," says Lowell L. Bryan, a McKinsey & Co. director and co-author of a new study called Economics of the New Economy.
Inflation bugs worry that once all businesses have embraced the Net, the gains from it will be over. But optimists say that won't happen for a long time. Take Commerce One Inc. of Pleasanton, Calif., which makes software that goes into online-procurement systems. President Robert Kimmitt says the company is already dreaming up software that could automate handling of exchange rates, taxes, and translation of documents. "You have to think of the Internet as a Pac-Man," says Kimmitt. "It's just looking for inefficiencies to gobble up."
The relentless pace of investment in those Pac-Man opportunities has vastly improved efficiency and helped keep inflation under control. Raising interest rates too far now might slow the pace of that investment. It's something that Greenspan and his crew will have to consider as they attempt to bring the U.S. economy safely into port.By Rich Miller in Washington and Peter Coy in New YorkReturn to top