09/ 20/ 2006
by Bill Dunkelberg
NFIB's chief economist responds to murmurs of rising inflation
There is a lot going on in the world today, and the future remains uncertain. Then again, what else is new? Political uncertainty is high with the turmoil in the Middle East and this summer's foiled airline terrorist plot. But the economic impact of those events isn't as clear. Equity markets don't like it; they're just not sure why. In the meantime, the Fed has been battling the inflation dragon with a team that doesn't have much policymaking experience. At a turning point like the one we're facing, experience is important, since setting policy is as much an art as it is a science.
How the Fed measures inflation: Currently, inflation (as measured by the Consumer Price Index) is accelerating at an annual rate of more than 4 percent. That means that if you're an average consumer, and you get a raise of 4 percent, you're still just breaking even. This is unacceptably high if it persists for a longer period of time. The Fed pays more attention to the core CPI, which is the cost of a basket of goods, excluding food and energy. The logic here is that even though the Fed is very powerful, it can't control oil prices or the weather. So now even core inflation is running well over 2 percent, outside of the presumed Fed preference of a 1 to 2 percent range.
Firms raise prices only when demand is strong--it's hard to raise prices in a recession! So the logic of the Feds' policy is simple: Raise interest rates until demand slows enough to keep firms from raising prices and perhaps even induces them to cut a little. This is a hard task, and historically the bulk of the burden of Fed policy falls on housing, the most interest-sensitive sector of the economy. Layoffs in the housing industry translate into less spending by laid-off or less well-paid workers, and the softness spreads to the rest of the economy, blunting price hikes and slowing inflation.
What we can expect: Currently, lots of small businesses are raising prices, more than 30 percent this year to date, according to monthly surveys conducted by NFIB. About 10 percent reported cutting prices--not enough to neutralize those that are raising prices. The result is inflation. We haven't experienced an episode like this since the late 1980s. That surge in prices was terminated by a recession, something the Fed hopes to avoid this time around (the so-called "soft landing"). The first stage of the policy response is now under way--housing is very soft, causing employment in that sector to suffer. The question is: How much will this impact the whole economy? Will we experience a soft landing (when growth just slows) or a recession (when output actually falls)? Firms respond to weaker demand with a lag, since nobody likes cutting prices and rarely will until they have to. So as the economy slows, price hikes will linger, and inflation will fade slowly--absent a shocking decline in oil prices, of course. The persistence of inflation doesn't mean the Fed has done too little--it just takes some time to work out.
