Turning points

May 12, 2004

THE COST of food is up. Gas at the pump is at an all-time high - averaging almost $1.93 for a gallon of unleaded. Manufacturing and construction indexes are strong. Mortgage and longer-term Treasury rates are spiking. And April job data released last Friday showed healthy gains for the second month in a row.

A year ago, the "D-word" - deflation - was in the air. Now, if inflation isn't exactly roaring back, the U.S. economy certainly seems to be at an inflection, a turning toward rising prices and interest rates. Some economists say that's already old news, and the Federal Reserve - in not raising short-term rates last week - is behind the curve; U.S. and world stock markets, this week hitting lows for the year, certainly aren't waiting. But the Fed at least formally shifted its attitude toward rates from "patient" to raising them in a "measured" way.

All this telegraphs the end of a remarkable era of record easy credit - some insist a credit bubble - that has sparked both record homeownership and consumer debt. A sudden spike in interest rates threatens those who've built houses of cards on variable-rate loans. But a measured dose might have some benefits: growth in corporate pricing power and even perhaps in still-lagging wages. Managing and moderating that transition is the delicate task before Fed chief Alan Greenspan, perhaps his final trick before his terms ends in 2006.

But here's the rub: Another central bank chairman, Zhou Xiaochuan, governor of the People's Bank of China, could rival Mr. Greenspan's impact on the U.S. inflation outlook. And the task before Mr. Zhou is even more challenging: slowing down the rip-roaring growth of the Chinese economy without triggering a sudden and massive financial meltdown that could reverberate across the Pacific and help send the U.S. economy back into the doldrums.

True, China has been exporting deflation to the United States in the form of cheap goods produced by an endless supply of cheap labor, a factor in weak U.S. wage growth. But increasingly, the overheated Chinese economy has been devouring all kinds of world commodities - iron and steel, oil and coal, cotton and grain - driving global prices skyward. In the first quarter of this year alone, fixed foreign investment in China rocketed by almost 45 percent over the same period last year, an unsustainable speculative bubble.

As Mr. Zhou tries to induce a controlled slowdown - via a still-fragile banking system in which an estimated 45 percent of all loans are now nonperforming - his instruments of control are much more bludgeon-like and a lot less reliable than those at Mr. Greenspan's disposal. China, for example, just initiated new price controls, bank audits and development limits.

So there are two turning points simultaneously playing out here, involving the increasingly joined twin engines of world growth and their two central banks. The more complex banking system is trying to effect a temperate response to the return of inflation - with one eye on the more rickety one's effort to safely douse the fires already raging through the world's fastest-growing major economy. It's long been said that when Mr. Greenspan speaks, U.S. and world markets listen. Now they also must pay close attention to his Chinese counterpart.

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