Facing Up To Inflation

If the Federal Reserve raises interest rates at the end of June, as seems probable, it will likely be criticized for making a fetish of inflation and, in the process, risking an American or global recession. There are already signs that the U.S. economy is slowing. Stock markets around the world have recently declined sharply. Why should the Fed make matters worse by

nudging up rates even a tad? This is a sensible-sounding complaint. Based on what we now know, it's also wrong.

We have an inflation problem that we need to cure before it gets worse. A central lesson of the past half century is that inflationary psychology, once embedded in price- and wage-setting practices, is stubborn and destructive. It leads to frequent recessions. It stunts the rise in living standards. People detest it. They're frightened by rapid and unpredictable price changes. We learned these lessons the hard way. From 1960 to 1979, inflation rose from 1.4 percent to 13.3 percent. Only the horrific 1980-'82 slump (peak monthly unemployment: 10.8 percent) repressed it.

The job of the Federal Reserve is "to take away the punch bowl just when the party gets going," William McChesney Martin Jr., the Fed chairman from 1951 to 1970, once famously said. As business cycles mature, inflationary and speculative pressures build. Demand begins to overtake supply. Companies find it easier to raise prices. Workers find it easier to win bigger wage increases. Greater optimism encourages riskier, often foolhardy, investments. The present economic expansion began in December 2001. It's now showing many telltale danger signs.

Inflation, though nowhere near double digits, is clearly rising. The government last week released the consumer price index for May. It was up 4.2 percent from a year earlier. The comparable figures for the last three years were 3.4 percent (2005), 3.3 percent (2004) and 1.9 percent (2003). Even these comparisons may understate the reality. In the past three months, the increase in the CPI on an annualized basis (projected for a year) is 5.7 percent.

The obvious remedy is to slow the economy's growth--make it harder for companies, workers and landlords to raise prices, wages and rents. But some economists contend that the Fed should discount the latest inflation reports and suspend any further interest-rate increases. (The Federal Open Market Committee meets June 28 and 29.) Here's the gist of their argument.

First, the Fed's been raising interest rates since June 2004. The overnight Fed funds rate has gone from 1 percent to 5 percent. Higher interest rates operate on the economy with a delay. Finally, the economy's responding. Home building and consumer spending are weakening. In May, industrial production dropped 0.1 percent. Eleven of 17 manufacturing sectors, including autos, declined. Wage increases have been modest. Inflation will subside; it, too, is a lagging indicator.

Second, inflation statistics are misleading and falsely alarming. Oil explains much of the surge. Gasoline prices are up 33.4 percent and home fuel prices, 13.5 percent in the past year. Obviously, the Fed can't change these. Without them, so-called core inflation (all prices except energy and food) is fairly tame. For the past year, it's 2.4 percent. Even this is skewed by a quirky housing component. The CPI doesn't count home prices directly. Instead, it converts rents into homeownership costs. Because rents are rising, so is homeownership. Weird, say critics.

You should treat these objections skeptically. It's not that they're wrong. But they can all be qualified. Yes, home building is down--but commercial construction is up. Yes, industrial production dropped in May--but it increased (0.8 percent) in April. Yes, core inflation is a useful concept if energy and food prices go down after they go up. But if oil prices stay up--as they are doing now--it's less useful. (Even so, core inflation is outside the Fed's comfort zone of 1 percent to 2 percent.) Yes, the CPI's housing component is quirky--but it's not necessarily wrong. Rents are rising partly because home prices have increased so much that more people are forced to rent. If the CPI counted home prices directly, it would have gone up much more in 2004 and 2005.

All these arguments aim to minimize the inflation threat. To anyone who knows the history, this is eerily reminiscent of the 1960s and 1970s. Then, economists underestimated inflation. They argued that a bit more wouldn't hurt or that increases reflected "temporary" pressures. In the resulting political and intellectual climate, the Fed pursued easy money and credit policies for too long. It tried to drive economic growth up and unemployment down. The results were perverse: double-digit inflation, four recessions from 1969 to 1982 and higher unemployment.

Since 1982 there have been only two mild recessions. The lesson is that low inflation promotes more stable economic growth. The Fed should heed that. True, it could trip into a recession. But without dramatic evidence of a weakening economy, the greater danger is a renewal of inflationary psychology. It's time for the punch bowl to go.