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[netodyssey]

Bernanke's nightmare?
By Rich Miller Bloomberg News

MONDAY, MAY 22, 2006


WASHINGTON The chairman of the Federal Reserve, Ben Bernanke, may be facing a central banker's nightmare this year: what Allen Sinai, president of Decision Economics in New York, terms "a mild dose of stagflation."

Surging oil and commodity prices, a falling dollar and mounting doubts about the Fed's willingness to keep price pressures in check are all increasing the risks that inflation will quicken in the United States. At the same time, the Fed's two-year credit-tightening campaign is beginning to bite; with the housing market sagging and consumer confidence wavering, the result may be slowing growth.

Call it stagflation lite. The toxic combination last seen in the 1970s and early 1980s is bad news for consumers, companies and investors.

Consumers find themselves squeezed by rising prices and diminishing job prospects. Profits take a hit as companies face mounting costs and diminishing demand. Investors' portfolios shrink with a swooning stock market.

It would also be bad news for President George W. Bush and his fellow Republicans, who have been counting on the economy's strength to revive their sagging popularity ahead of November congressional elections.

No one foresees a return to the bad old days of the 1970s and early 1980s, when unemployment and inflation both soared to post-World War II highs. In the 1970s, for example, the jobless rate peaked at 9 percent while inflation topped out at 13.3 percent. One big difference now is strong productivity growth, which helps keep inflation in check and the economy growing. Nonfarm productivity grew 2.7 percent last year; contrast that with 1979-80, when productivity shrank.

Still, Jan Hatzius, the chief U.S. economist at Goldman Sachs, sees a risk of growth slowing to 2 percent later this year, from almost 6 percent in the first quarter. Brian Wesbury, chief economist at First Trust Advisors, talks of the possibility that core inflation, which excludes volatile food and energy costs, will rise above 4 percent next year, close to double last year's level.

If they are both right, it may prove very uncomfortable for Bernanke, who took over leadership of the central bank in February.

"The Fed's in a very precarious position," says Stephen Cecchetti, a former research director for the Federal Reserve Bank of New York and now professor of international economics at Brandeis University. "Inflation is going to be pretty high by their standards, while growth is going to be slowing."

Just as in the 1970s and early 1980s, oil prices are surging, tripling over the past three years. While energy costs so far have not fed through much into core inflation, that may be changing. Through the first four months of the year, core inflation rose at an annualized rate of 3 percent versus 2.2 percent last year.

Meanwhile, back-to-back years of 3.5 percent-plus growth leave less slack in the U.S. economy. In April, U.S. industry operated with less spare capacity than at any time since July 2000.

Spare capacity is dwindling globally as well. The International Monetary Fund projects global growth of 4.9 percent this year, after 4.8 percent in 2005 and 5.3 percent in 2004, the strongest three-year stretch since the early 1970s.

That reduces the so-called global output gap, the excess of world supply over demand, and makes it easier for multinational companies to raise prices without fear of losing business to competitors.

Fuji Photo Film, Japan's biggest film maker, said last week that it would raise prices on photographic film and other products by as much 20 percent to cover increasing costs for silver, oil and other raw materials. The increase, the biggest since 1980, follows a price rise of as much as 17 percent by Eastman Kodak, the world's biggest film maker.

"Price pressures are the strongest seen since the ugly 1970s and early 1980s," says William Dunkelberg, a professor at Temple University who is also chief economist of the National Federation of Independent Business, a group representing small businesses.

Bernanke argues that the economy is different now because inflation expectations remain contained. That is important because if companies and workers believe inflation is headed higher, their actions may help bring that result. Companies will raise prices while workers will demand higher wages.

Some signs suggest inflation expectations are edging up. The gap between yields on 10-year U.S. Treasury notes and comparable inflation-linked government debt has widened to 2.6 percentage points from 2.3 points at the start of the year. The difference reflects investors' expectations for what inflation will average over the next decade.

"The danger is the Fed loses its inflation-fighting credibility," said Bill Healey, senior vice president of interest rate products at GE Asset Management.

While inflation expectations are rising, the housing market shows signs of buckling after the Fed's 16 interest rate increases since June 2004. Housing starts fell 7.4 percent in April to a 17- month low. Homebuilder confidence in May was at its lowest point in almost 11 years. Consumer confidence tumbled this month by the most since last year's hurricanes. A University of Michigan survey found that consumers are less inclined now to buy a home or a car than at any time in more than a decade.

Wal-Mart Stores, the world's largest retailer, said last week that earnings might suffer this quarter as near-record gasoline prices caused consumers to cut back on other purchases.

If subpar growth and too-high inflation comes about, Bernanke and his colleagues will face unpalatable choices. Do they raise interest rates to squelch rising inflation and risk sending the economy into a tailspin? Or do they forgo increases in rates - even cut them - to cushion the declining economy and in the process run the danger of letting inflation accelerate?

Economic historians like the New York University professor, Thomas Sargent, said it was the Fed's mishandling of monetary policy, rather than the steep rise in oil prices, that was behind the economy's performance in the mid- to-late 1970s. That may be enough to keep Bernanke and his fellow Fed policy makers awake at night.

WASHINGTON The chairman of the Federal Reserve, Ben Bernanke, may be facing a central banker's nightmare this year: what Allen Sinai, president of Decision Economics in New York, terms "a mild dose of stagflation."

Surging oil and commodity prices, a falling dollar and mounting doubts about the Fed's willingness to keep price pressures in check are all increasing the risks that inflation will quicken in the United States. At the same time, the Fed's two-year credit-tightening campaign is beginning to bite; with the housing market sagging and consumer confidence wavering, the result may be slowing growth.

Call it stagflation lite. The toxic combination last seen in the 1970s and early 1980s is bad news for consumers, companies and investors.

Consumers find themselves squeezed by rising prices and diminishing job prospects. Profits take a hit as companies face mounting costs and diminishing demand. Investors' portfolios shrink with a swooning stock market.

It would also be bad news for President George W. Bush and his fellow Republicans, who have been counting on the economy's strength to revive their sagging popularity ahead of November congressional elections.

No one foresees a return to the bad old days of the 1970s and early 1980s, when unemployment and inflation both soared to post-World War II highs. In the 1970s, for example, the jobless rate peaked at 9 percent while inflation topped out at 13.3 percent. One big difference now is strong productivity growth, which helps keep inflation in check and the economy growing. Nonfarm productivity grew 2.7 percent last year; contrast that with 1979-80, when productivity shrank.

Still, Jan Hatzius, the chief U.S. economist at Goldman Sachs, sees a risk of growth slowing to 2 percent later this year, from almost 6 percent in the first quarter. Brian Wesbury, chief economist at First Trust Advisors, talks of the possibility that core inflation, which excludes volatile food and energy costs, will rise above 4 percent next year, close to double last year's level.

If they are both right, it may prove very uncomfortable for Bernanke, who took over leadership of the central bank in February.

"The Fed's in a very precarious position," says Stephen Cecchetti, a former research director for the Federal Reserve Bank of New York and now professor of international economics at Brandeis University. "Inflation is going to be pretty high by their standards, while growth is going to be slowing."

Just as in the 1970s and early 1980s, oil prices are surging, tripling over the past three years. While energy costs so far have not fed through much into core inflation, that may be changing. Through the first four months of the year, core inflation rose at an annualized rate of 3 percent versus 2.2 percent last year.

Meanwhile, back-to-back years of 3.5 percent-plus growth leave less slack in the U.S. economy. In April, U.S. industry operated with less spare capacity than at any time since July 2000.

Spare capacity is dwindling globally as well. The International Monetary Fund projects global growth of 4.9 percent this year, after 4.8 percent in 2005 and 5.3 percent in 2004, the strongest three-year stretch since the early 1970s.

That reduces the so-called global output gap, the excess of world supply over demand, and makes it easier for multinational companies to raise prices without fear of losing business to competitors.

Fuji Photo Film, Japan's biggest film maker, said last week that it would raise prices on photographic film and other products by as much 20 percent to cover increasing costs for silver, oil and other raw materials. The increase, the biggest since 1980, follows a price rise of as much as 17 percent by Eastman Kodak, the world's biggest film maker.

"Price pressures are the strongest seen since the ugly 1970s and early 1980s," says William Dunkelberg, a professor at Temple University who is also chief economist of the National Federation of Independent Business, a group representing small businesses.

Bernanke argues that the economy is different now because inflation expectations remain contained. That is important because if companies and workers believe inflation is headed higher, their actions may help bring that result. Companies will raise prices while workers will demand higher wages.

Some signs suggest inflation expectations are edging up. The gap between yields on 10-year U.S. Treasury notes and comparable inflation-linked government debt has widened to 2.6 percentage points from 2.3 points at the start of the year. The difference reflects investors' expectations for what inflation will average over the next decade.

"The danger is the Fed loses its inflation-fighting credibility," said Bill Healey, senior vice president of interest rate products at GE Asset Management.

While inflation expectations are rising, the housing market shows signs of buckling after the Fed's 16 interest rate increases since June 2004. Housing starts fell 7.4 percent in April to a 17- month low. Homebuilder confidence in May was at its lowest point in almost 11 years. Consumer confidence tumbled this month by the most since last year's hurricanes. A University of Michigan survey found that consumers are less inclined now to buy a home or a car than at any time in more than a decade.

Wal-Mart Stores, the world's largest retailer, said last week that earnings might suffer this quarter as near-record gasoline prices caused consumers to cut back on other purchases.

If subpar growth and too-high inflation comes about, Bernanke and his colleagues will face unpalatable choices. Do they raise interest rates to squelch rising inflation and risk sending the economy into a tailspin? Or do they forgo increases in rates - even cut them - to cushion the declining economy and in the process run the danger of letting inflation accelerate?

Economic historians like the New York University professor, Thomas Sargent, said it was the Fed's mishandling of monetary policy, rather than the steep rise in oil prices, that was behind the economy's performance in the mid- to-late 1970s. That may be enough to keep Bernanke and his fellow Fed policy makers awake at night.


http://www.iht.com/articles/2006/05/21/bloomberg/bxecon.php