Economist's Corner: Punch bowl economics

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By Carl Steidtmann, chief economist and director, Consumer Business, Deloitte Research

Unfortunately, I expect little progress to be made in reducing core inflation this year or next, and I am skeptical that slower economic growth will help.

Philadelphia Federal Reserve President Charles Plosser

Former Federal Reserve Chairman William McChesney Martin once said that the job of a good central banker is to take away the punch bowl just as the party gets going. For the past few years, the U.S. economy experienced a rocking great party. During that time, the Fed failed to take away the punch bowl as the party spun out of control, leaving a mess in the housing market and severe problems on the balance sheets of banks.

When financial crises struck in the past, the Fed could ease credit with the confidence that it was not risking spiking the punch bowl once again. The Fed’s confidence came largely from the financial market response to past international credit events. From the Mexico debt crisis in 1995, to the Asian currency crisis in 1998, market fears created a rush to credit quality and in the past that meant a rush into dollars. Credit crises, by their very nature tend to be deflationary. They destroy credit, reduce demand and tend to push prices lower. So why then is Fed President Plosser suggesting that might not be the case this time?

The current credit crisis is a little over a year old. During that time the dollar has lost roughly 10 percent of its value. Over a similar span of time, following the onset of the Asian currency crisis, the dollar had gained over 7 percent in value. The direction of the dollar is significant. Instead of giving U.S. economic management a vote of confidence, international investors have been doing just the opposite. That lack of confidence in U.S. economic leadership is going to have a direct effect on prices both in the United States and around the world as it has resulted in less foreign investment in the United States and a weaker currency.

Economic leadership at both the Bank of England and the European Central Bank has taken a very different approach. Mervyn King, the governor of the Bank of England, recently raised the bank’s inflation outlook and warned that interest rates would have to be kept higher than what many investors were expecting to dampen down inflation. At the European Central Bank, President Jean-Claude Trichet has gone on record defending the bank’s decision not to cut rates by denouncing interest-rate activism as an improper response to the current financial market turbulence.

The weakness in the dollar’s value is showing up in commodity markets and import prices. It is also showing up in the prices that domestic manufacturers are able to charge their customers and service providers get for their services. The diffusion index of prices received by manufacturers rose in January to 78. A reading above 50 is a sign of accelerating inflation. By contrast, following the Asian currency crisis, the ISM price index fell to as low as 32 in late-1998. Service price inflation also compares poorly with the ISM price index for services coming in at 48.5 at the end of 1998 and 70.7 in January. A weak dollar is giving domestic producers, both manufacturers and service businesses pricing power even as the economy weakens.

No where is the impact of a declining dollar on inflation more apparent than in the price of food and energy.

Since the Fed began aggressively easing credit in August, oil prices have soared nearly 50 percent. The effect of the Fed’s easing has had a more powerful impact on oil prices than did the loss of 1 million barrels of production capacity due to Hurricane Katrina back in 2005. For consumers, rising oil prices act as a tax on non-energy spending and accounts in part for the weakness of traditional holiday spending.

Food prices have also moved higher in the past year. Grain prices have soared as global stocks have diminished and non-U.S. crop yields have fallen. Government subsidies for ethanol, coupled with a weaker dollar have pushed food inflation to its fastest pace of growth in 17 years and then the Fed was tightening credit. You have to go back to the late 1970s when food inflation was accelerating and the Fed was easing to find a similar policy mix. The result of that mix was substantially higher inflation.

Rising inflation is a mixed blessing. It gives the impression of growth with out many of the difficulties that are usually involved in boosting the top line. It can also create a lax approach to productivity and cost control as sales growth becomes an expectation. One downside of higher inflation is that costs more often than not rise faster than your ability to raise prices.

The biggest downside of higher inflation comes when the Federal Reserve once again tries to squeeze it out of the financial system. As we learned in the early 1980s, inflation is a little like weight gain. It sneaks up on you when you least expect it. You gain a pound here and a pound there then comes the holiday season and, wham, before you know it you’re 10 pounds over weight. Losing that weight is always a lot harder then gaining it. And so it will be with the current round of inflation when the Fed eventually comes again to take away the punch bowl.