Price stability is a terrible thing to waste

Hope is a wonderful thing, but at some point it becomes the enemy. It’s hard to know exactly when a friend turns foe, especially when so many of the old rules go out the window. Hindsight, in other words, is the only true source of clarity, which leaves mere mortals like us with the thankless task of dissecting trends in real time. Good luck with that, as they like to say down at the University of Hard Knocks.

Once again, our work is cut out for us with the challenge du jour: deciding if today’s update on wholesale prices reflects momentum or another irregular set of data that will soon reverse. As a preview, it’s safe to say that at face value the numbers look bad. The Producer Price Index for July jumped 1.2%, the Bureau of Labor Statistics reports. The good news is that the 1.2% pace is down from June’s nosebleed 1.8% rise. But that’s about the extent of the positive-spin potential in today’s PPI numbers.

On a rolling 12-month basis, PPI is now surging upward by 9.8% a year, as of last month. That’s the highest annual rate since 1981, when inflation was universally hailed as a threat to the economy and livelihoods of the men and women in the street. It’s debatable how the Federal Reserve views PPI and other pricing data these days, but it’s clear what the consensus was among monetary authorities all those years ago.

Meanwhile, forget about looking to core PPI as a reason for optimism that pricing momentum isn’t as bad as headline PPI suggests. PPI less food and energy rose by 3.6% for the 12 months through July 2008–the highest since 1991. As our chart below reminds, this surge in core PPI is no recent event. Upward momentum in core PPI has been building for some time. And as economic history so clearly teaches, slowing if not ending a runaway train in matters of pricing takes time; and the longer the train rolls on, the higher the economic price tag.


Considering that PPI is advancing at a time when consumer prices also look threatening suggests that now is a time for action. Why, then, does the Federal Reserve sit on its monetary hands by keeping interest rates unchanged at a 2% Fed funds rate? The answer of course can be summarized by the phrase “dual mandate.” The Fed, in contrast to its European counterpart, must promote economic growth and minimize inflation. This may or may not be a plus, but it’s definitely a burden. Is it a burden that exceeds the limits of central banking? We may soon find out. Let’s just say that your editor is keeping an open mind as to the outcome, at least for the conclusion of this cycle.

Mr. Market is starting to come around to the idea that rates will rise, sort of. The idea of higher rates is embraced reluctantly, as witnessed by the March ’09 Fed funds futures contract, which currently is just barely priced in anticipation of a 25 basis point hike between now and next spring. For good or ill, the market’s not expecting much change, if any, any time soon in the land of interest rates.No one should be cavalier about the prospect of job losses and the resulting pain that falls on the average worker. But let’s also recognize that Joe Sixpack will be hurt by higher inflation too. Deciding how much pain to allow in one vs. the other is a thankless task, and one that can only be managed generally, if at all. Monetary policy, as economists like to say, is a blunt instrument. As an analogy, think of trying to thread a needle with mittens and you’ll have a sense of what it’s like to manipulate the price of money as a tool for economic salvation.

Nonetheless, it’s time for the Fed to at least send a minor message that it’s a) alert to the inflation threat; and b) willing to act, if only marginally. A 25-basis-point hike in Fed funds, unannounced on, say, Thursday, would be a good start. No, that wouldn’t cure inflation per se, but it would send a message. A thousand mile journey, as they say, requires a first step. Meanwhile, a 25-basis-point rise by itself would hardly alter the labor market outlook one way or the other. In fact, we can debate how effective the Fed’s rate cuts over the past year have been in easing economic pain. Indeed, it’s hard to argue that the ills affecting the economy are born of interest rates that were too high.

Still, there are no good choices. We’re long past that point. At best, we’re now looking at the least-worst decisions and its all down hill from here. But this much is clear: doing nothing at this point looks increasingly reckless. Yes, the inflationary momentum that’s been bubbling for some time may suddenly pass away, in which case we can always lower rates again. Let’s recognize that a weakening global economy promises to take the edge off inflation. The question: How long should we wait for that day of reckoning? Something less than forever is a reasonable answer, but it get fuzzy beyond that.

That leaves us with: What if inflationary pressures don’t soon evaporate? We all know the answer, and so does the Fed. For now, Bernanke and company are betting the farm on a slowdown, both here and abroad. Hope, it seems, will remain official strategy for a while longer.

Originally published at The Capital Spectator and reproduced here with the author’s permission.