Inflation and Fox Hunts

Imagine a hunt in which the Master of Fox Hounds is replaced just as the pack picks up the scent. Add a dense fog. That's a good description of the circumstances in which the Federal Reserve Board's monetary policy gurus find themselves as they hunt for the interest rate that will allow the U.S. economy to grow at a sustainable, non-inflationary rate at a time when their leader, Alan Greenspan, is about to be replaced by Ben Bernanke.

The Fed knows a few things with a reasonable degree of certainty. The storm-tossed economy continues to grow at a rapid rate. The latest preliminary figures -- because of Katrina, emphasis must be on "preliminary" -- show that third-quarter GDP grew at an annual rate of 3.8% and suggest that it would have grown at a sizzling 5% had it not been for a temporary reduction in private inventories and the impact of Katrina. The economy now has grown at a rate of more than 3% for ten consecutive quarters.

It knows, too, that almost all sectors racked up good gains, reducing any slack that might have existed in labor and spare capacity in the manufacturing sector. Consumers continued to storm the shops, increasing their spending at a 3.9% annual rate. Business investment rose at a 6.2% rate, boosted by an 8.9% jump in spending on equipment and software. Government spending also rose, at a 3.2% rate, due to a rise in defense spending.

Although Secretary of the Treasury Snow promises that this time the president really means it when he says he will rein in spending so as to cut the deficit in half, to a low 2% of GDP, Greenspan views this pledge with appropriate skepticism. After all, President Bush and Congress have combined to pour gallons of red ink over the federal ledgers despite a15% increase in federal revenues in the fiscal year ended September 30.

Finally, the Fed knows that its preferred measure of core inflation has risen to the top of the 1%-2% range that incoming chairman Ben Bernanke and several Fed policy makers call their "comfort range." Throw in energy and food, which are excluded from the core rate and the increase was 3.8%. More attention is being paid to the latter figure than in the past, since it is increasingly possible that what the Fed in its statement called "the cumulative rise in energy … costs" will seep through to other goods. Energy-intensive Dow Chemical, for example, raised prices for its chemicals by 12% in the third quarter, the eleventh consecutive quarter in which it found that it now has sufficient pricing power to enable it to offset rising energy costs, and then some.

So the Fed decided to continue its "measured" increase in interest rates, and last week announced the 12th consecutive increase, taking the fed funds rate (charged between banks on overnight loans) from its 46-year low of 1% in June 2004, to 4%. So far, so clear, at least to the Fed: inflation is struggling to get out of the box in which it has been locked for years, and the Fed is determined to keep the lid on.

But then the fog descends. For one thing, no one really knows just what the object of the Fed's hunt is. Yes, all are agreed that it is the rate that will neither stimulate nor restrain economic growth. Asked the level of this Holy Grail, the so-called neutral rate of interest, Greenspan not-too-helpfully replied, "We probably will know it when we are there." Some of his colleagues put the number at 4%, which would suggest an end to "measured increases," but a new consensus is forming around the significantly higher 5% rate.

The impossibility of knowing just where to take interest rates is not the Fed's only problem. It faces what its chairman calls a "conundrum": long rates refuse to follow short rates, thereby immunizing the housing market and other sectors from its decisions. Bernanke attributes this to the fact that there is a global savings glut, so much money sloshing around the world economy looking for a place to go that the demand for bonds and other interest-bearing securities is virtually insatiable. Others think that we merely witnessed a lag before markets caught on to the fact that inflation is once again a threat, and note that long-term rates have recently turned up, and are at their highest level since March. Besides, studies by the International Monetary Fund conclude without saying so that Bernanke has got it wrong, and that global savings "are near historic lows." No glut, merely a fall in savings in industrial countries, partially offset by a rise in savings in emerging markets.

Adding to the Fed's woes is the difficulty of predicting where the economy is headed. There is by no means a consensus that the economy is on such a tear that further interest rate increases are needed. The confidence of America's heavily indebted consumers is at a 13-year low. A prospective slowing in the rate of household formation suggests that although we are unlikely to hear the sound of a bubble bursting, the long period of house-price inflation is over, and with it the ability of consumers to finance their spending by borrowing against the increased value of their homes ("equity extraction" in city jargon). On the cost side, productivity continues its long rise, and the globalization of the work force has added hundreds of millions of workers to the labor supply, putting downward pressure on wages and labor costs. Indeed, global inflation is actually declining in response to increasing supplies of many tradable goods. So say those who see the Fed headed towards recession-inducing "overshoot."

The Master of the Foxhounds has an advantage over the Fed: the hunters must obey him, and he knows what he is hunting for. The economy has no obligation to obey the Fed's policymakers, who don't even know whether their prey is 4%, 5% or some other level of interest rates.

A version of this article appeared in the Sunday Times (London) on November 6, 2005.