Inflation has been subdued for so long that in the last couple of years economists, academics and officials at the Federal Reserve were more concerned about the possibility of deflation – a period of falling prices – than they were about inflation. As it happened, deflation never did come to pass and there is not much talk about it these days. Inflation, however, is very much back in the news.
Fed watchers do not think that the United States is headed for the kind of rampant inflation that ravaged businesses and consumers during the Carter administration and early years of the Reagan administration. But developments on the price front have reached enough of a critical mass that the financial markets expect the Fed to raise interest rates in the coming months to keep prices from spiraling.
The key question is how hard-hitting the Fed will be. A May 21 story in The Wall Street Journal suggested that the Fed may need to be more vigorous than it had planned just a few months ago because consumer prices rose more sharply in April – at an annual rate of 2.3% – than had been anticipated. In January, inflation rose at an annual rate of just 1.1%. The Journal article also noted that the Fed is looking closely at how wage and employment costs, not just consumer prices, might affect inflation.
“I don’t think we’re going to go back to the levels of inflation that we saw in the ’70s because I think the Fed will do what’s necessary this time to keep inflation under control,” says Wharton finance professor Skander Van den Heuvel. “That is going to involve raising interest rates, and the market expects that. The question is how aggressive the Fed will be and how soon the Fed will raise rates. It’s not completely clear what state the economy is in right now. The latest data indicate inflation is picking up. On the other hand, unemployment is still relatively high, given the recent history of the ’90s. There’s also some evidence there is still some slack in the economy. So maybe we don’t need to worry about inflation that much yet.”
When deflation was a concern, Federal Reserve Chairman Alan Greenspan said that the Fed would be accommodating for a considerable period in order to encourage economic activity. “Those statements in the past could be reason for the Fed to not raise rates as fast as it might otherwise want to do, given economic conditions,” adds Van den Heuvel. “If it were to be perceived as raising rates too fast, it would lose some credibility.”
Van den Heuvel expects the Federal Open Market Committee to raise its target for the federal funds interest rate, which is currently 1%, by one-quarter of a percentage point (or 25 basis points) at its meeting on June 30. “To raise that rate by a half point would be perceived as too much too soon by the markets, “he says. “The Fed will be careful.” The fed funds rate is the rate charged by banks on overnight loans.
Stuart G. Hoffman, senior vice president and chief economist at the PNC Financial Services Group in Pittsburgh, says the Fed will raise the Fed funds rate by 25 basis points at its June meeting. He says that this increase will mark the beginning of a series of quarter-point hikes that will continue over the next 18 months and culminate in a Fed funds target of 3% to 3.5% by the end of 2005.
“I am concerned that inflation is moving higher and that all the risk to inflation is on the upside,” says Hoffman. “The good thing is inflation is very low to begin with. It’s starting from a very low level. We had 1% to 1.5% inflation in 2003. That’s the lowest in 40-some years. But while starting low, inflation is definitely moving up and could move up to a rate that becomes adverse to the U.S. economy and the markets.”
Wharton finance professor Jeremy Siegel says that labor costs are important for the Fed to take into account but “there is not much inflation” in some recent labor figures. “Hourly wages have stayed quiescent,” he wrote in a May 22 commentary posted on his website, jeremysiegel.com. The Bureau of Labor Statistics’ most recent hourly wage report, for April, showed a 0.3% increase, compared to a meager 0.1% increase in March. Year-over-year wages were up 2.2% in April, compared to 1.6% in March, but are “still quite low” in Siegel’s view.
But another measure of wage costs, the government’s Employment Cost Index, “is a bit more threatening,” according to Siegel. March ECI data showed an annual increase of 4.5%, much of it due to the sharp rise in benefit costs, which rose 7% on a year-over-year basis in March, the highest since 1990. Siegel compared today’s labor cost data with figures from 1994, the last time the Fed raised rates aggressively. He expected to find stronger wage pressures at that time but did not. Today’s wage pressures are ameliorated by robust productivity growth, which is about 4% today compared to 1% in 1994. But Siegel says a rising ECI may be one of the factors that will prompt the Fed to boost rates by more than 25 basis points later this month.
“The question is whether the difference in productivity growth today compared to 10 years ago justifies the 300-basis-point difference between the [fed] funds rates,” Siegel wrote. “I would say: Barely. But Greenspan was forced to raise the funds rate from 3.00% to 6.00% in 1994 because the 3% rate was seen as too low. I believe the market is saying the same thing now … I still believe a 50-basis-point hike is possible at the June 30 meeting.”
In a speech on May 11, Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia and a former finance professor at Wharton, said he expects inflation to remain at an “acceptable level.” Santomero predicted that real gross domestic product will grow 4% to 5% in 2005, “somewhat above its long-term potential,” with demand being driven by more robust business investment spending and consumer spending.
At the same time, the high rate of productivity growth that the United States has enjoyed in recent years will “recede” and “employment will increase at a pace strong enough to significantly reduce the slack in labor markets,” according to Santomero. “The improving job market, in turn, will reinforce growth in consumer spending, so that the expansion becomes truly self-sustaining. As the economy approaches its long-run potential, inflationary pressures may increase, but with this convergence coming gradually and inflation expectations well-contained, I expect inflation to remain at an acceptable level.”
As this process unfolds, “monetary policy can proceed from its current very accommodative position to a less accommodative and, ultimately, neutral stance, at a measured pace,” Santomero said in the speech. “Indeed, if the economy performs as I have outlined, such adjustments in the stance of monetary policy will be essential to forestalling any significant increase in inflation, and thereby laying the groundwork for a long expansion.” Santomero did not spell out what that “neutral stance” would be in terms of the Fed funds target rate – that is, a policy that is neither stimulative nor contractionary.
“Nobody knows exactly where neutrality lies,” Hoffman notes. “It’s not a number; it’s a zone. My guess is neutrality is [a Fed funds target] between 3% and 4% – well above 1%, where we’re at currently.”
If the sentiment of 32 professional forecasters surveyed in May by the Philadelphia Fed is any indication, inflation, as measured by the consumer price index, is indeed picking up steam. The forecasters said that the annual inflation rate will be 2.7% in 2004 and 2.2% in 2005. That is an increase from their projections of 1.6% and 1.9%, respectively, in a Fed survey conducted three months earlier.
What’s behind the increase in inflation? Higher prices for a variety of commodities, including oil. A survey by PNC for its spring economic outlook survey, published in May, showed that 52% of business owners nationally expected their suppliers to raise prices over the coming six months. In addition, 31% of business owners said they expect to pass along these higher costs to their customers.
Paul R. Kleindorfer, professor of decision sciences, economics and business and public policy at Wharton, notes that, historically, periods of inflation can differ in both their characteristics and ripple effects. “Every period of impending inflation is different,” Kleindorfer explains. “This one is more specifically focused on particular areas of the economy,” most prominently the energy sector. Already, sales of sport utility vehicles are down and people are expected to curtail their summer travel plans.
“Surveys shows significant planned changes in travel plans for vacationing based on the anticipation that people just won’t be able to afford the kind of travel they thought they’d engage in,” Kleindorfer says. “We will see effects of that on tourist centers all over the country, from Williamsburg to Yellowstone.” With oil prices high, consumers and companies alike may look to natural gas as an alternative source of energy. As demand rises, natural gas prices may shoot up, too.
Hoffman of PNC notes that the rate of inflation in the months and years to come could be affected by any number of developments. A terrorist attack in the United States could rattle consumers and businesses, reduce the level of spending, cut the rate of economic growth, and reduce inflationary pressures. Further turmoil in the Middle East, on the other hand, could reduce the supply of oil and put upward pressure on petroleum prices. In Hoffman’s estimation, if the inflation rate were to reach, say, 4%, “the Fed will have to be more aggressive and get rates up sooner and faster, and maybe even [approve] bigger increases.”
During presidential election years, there is always speculation that the Fed will tailor its decisions to accommodate the incumbent administration. But Hoffman says history does not support such an assumption.
“The Fed has raised rates in presidential election years and it’s lowered them,” he says. “There does not appear to be any pattern about rates going up or down because it’s a presidential election year. I suspect the Fed will raise rates in June and again in August and then probably wait till after the election. It meets one time after that [before the end of 2004]. It may well just say, ‘Let’s sit this one out; we’ve raised rates twice.’ It’s not unusual for the Fed to watch and wait to reassess. I don’t think the election is having much of an impact on the Fed.”
