ALAN GREENSPAN famously described the failure of long-term interest rates to rise in tandem with the increases he is engineering in short-term rates as a conundrum, a puzzle. The Fed chairman might with even greater accuracy describe the situation in which he now finds himself as a quandary, a state of extreme perplexity.
Start with the contradictory nature of the information about the state of the economy. Last week the government reported that the producer price index jumped 1 percent in July, and that even after volatile oil and food prices have been stripped out, the core index rose a surprising 0.4 percent. Surely that is an indication that inflation is taking off, that high oil prices are finally seeping into the prices of other goods, and that interest rates should be raised.
Well, not so surely. It turns out that the core index was driven upward by seasonal factors and a rise in car prices from their June level. Given the wild discounting that is going on in showrooms around the country, that reported rise might be a blip in the data, and is not a reliable harbinger of things to come in the highly competitive auto market.
The Federal Reserve Board chairman’s crystal ball is made even cloudier by uncertainty as to just how fast the economy is growing. Initial reports suggested that the economy grew at an annual rate of 3.4 percent in the second quarter, and many observers, this writer included, expected that figure to be revised upward when the final tally is made. But it turns out that subsequent reports of an unexpectedly large spurt in imports mean that consumers bought so many cars, T-shirts and TVs from abroad that growth in domestic output might have been lower than the original data suggest.
Greenspan also has to wrestle with major uncertainties concerning the state of the housing market–hot in some areas, cooling in others–and the rate at which productivity is increasing. With the labor market tightening, and wages inching up, offsetting increases in productivity are needed to keep labor costs under control. So inflation-fighters view with alarm the recent decline in the increase in productivity. Output per hour in the non-farm sector–the most widely watched measure of productivity–rose at a rate of only 2.3 percent in the past year, a big drop from the 5 percent pace in 2003.
That worry might be misplaced. It turns out that productivity in the nonfinancial corporate sector–the measure that Greenspan watches most closely–rose at an annual rate of 5.4 percent in the first quarter, significantly faster than the 4.5 percent rate at the end of 2003.
Greenspan is a master at sorting through these conflicting data, adding to the data mix the information he constantly receives from his wide-ranging contacts in the business community. The evidence suggests that despite worries about a bit of froth in some property markets, and concern about the rate at which the federal government is capable of spending money, he is satisfied that the economy is on a sustainable growth path, and that his policy of “measured” interest rate increases is just the thing the economy needs to prevent inflation.
WHICH BRINGS US TO OIL PRICES. The rise of crude oil prices to and above $65 per barrel, and of gasoline prices to $3 per gallon in parts of the United States, has fueled inflation fears, if not inflation itself. In the past, monetary policy makers have responded by raising interest rates. That was a mistake. “The simple-minded notion that because oil prices are going up you need to tighten would be a huge policy error,” says Harvard professor William Hogan, who has analyzed every oil supply interruption and price spike that has afflicted American consumers. Given the ample slack in the global economy, he adds, it would be folly to tighten monetary policy in response to a rise in the price of oil, rather than a jump in the general price level.
Indeed, other things being equal, the Fed would be tempted to loosen monetary policy to offset the drag created by the higher oil prices that are already causing some pain for Wal-Mart’s customers. But other things aren’t equal. Against the oil-price drag policymakers must set facts pointing to continued growth this year and next:
* the housing sector is booming in response to growing demand,
* the business sector is awash in cash after nine consecutive quarters of double-digit profit growth,
* unit labor costs, “which have typically been a key driver of inflation during periods of strong demand,” according to James Cooper and Kathleen Madigan of BusinessWeek, are rising at the fastest pace in five years, and
* the rising trade deficit, and the desire of foreign central banks to diversify their reserves out of dollars, will eventually weaken the dollar, forcing up the price of imports and allowing domestic producers to raise prices.
None of this is news to Greenspan. My guess is that he will neither panic–and accelerate the interest rate increases he is planning in his hunt for the level that will neither speed up nor slow down the rate of economic growth–nor abandon his current “measured” increases, at least not just yet. He is unlikely to loosen policy to accommodate higher oil prices, until he has a strong indication that the drag they create is overwhelming the growth-creating forces that are now driving the economy.
Steady as she goes is likely to be Greenspan’s message, at least for now.
Irwin M. Stelzer is director of economic policy studies at the Hudson Institute, a columnist for the Sunday Times (London), a contributing editor to The Weekly Standard, and a contributing writer to The Daily Standard.
