The new chairman of the Federal Reserve is deadly serious about stopping inflation, experts say, and if that causes the economy pain, get ready to suffer.
Yesterday, for the second day, Wall Street shuddered in response to Chairman Ben S. Bernanke's remarks Monday that the central bank would remain "vigilant" to insure that recent increases in inflation do not become chronic. The Dow Jones industrial average temporarily dropped below the 11,000 level yesterday for a two-day loss of 246 points, or 2.2 percent. It closed at 11,002.
Economists say that Bernanke's comments represented a clear signal that he will continue to raise interest rates to defeat inflation, a latent economic menace that terrifies policymakers but one that most Americans under the age of 45 have no clear memory of experiencing.
Bernanke made his comments at a time when the economy appears to be slowing, businesses are doing less hiring and concern is growing about the real estate market. Orders for new homes have fallen substantially during the past two months, sending the stock of homebuilders sinking.
The battle over inflation represents a telling moment for the U.S. economy, and thus the world, because of America's size. It pits Bernanke's untested ability to lead against the global upward pressure on prices. Expensive oil, a globalizing economy and demands for resources overseas all are driving the cost of living higher.
China and India, in particular, are buying enormous amounts of oil, copper, zinc, lumber, steel and other basic commodities.
Bernanke has one significant tool in his arsenal to bring about price stability - control over interest rates - but he has to get the formula right. If the Fed raises rates - and thus, the cost of borrowing money - high enough, the economy will begin to slow as demand for goods and services weakens. Eventually prices stabilize and inflation is defeated.
The fear is that if interest rates go too high, it will throttle the economy and push the nation into recession.
"He has to establish that he is in charge and he knows what he is doing," said Michael Miller, associate professor in the department of economics at DePaul University,
It is considered a risk worth taking because the enemy is so dangerous: Inflation is corrosive and invasive and eventually toxic.
As prices start to rise, people assume they will continue to do so, and inflation begins to feed on itself. For example, suppliers impose price increases on businesses, who pass the increase onto consumers, who clamor for pay raises.
Distortions in the economy appear. Consumers are induced to buy today rather than save their money because prices are apt to be higher tomorrow and the money worth less. Some people flee cash or stocks and bonds for hard assets like gold and silver, which they perceive as a better store of value. And interest rates can rise sharply because investors demand more money to compensate for the diminished value of the payments they will receive in the future.
All that last happened in the 1970s, when spending on the Vietnam War, followed by a big jump in oil prices, ignited inflation not seen in decades.
The Fed eventually responded by pushing interest rates sky-high. Under Fed Chairman Paul A. Volcker, double-digit interest rates squeezed inflation pressures out of the economy. But it didn't just cool; by the early 1980s it was deep in recession with unemployment in double digits in many states. Nevertheless, inflation was largely snuffed out for a period of more than two decades.
Under the leadership of Alan Greenspan, the Fed became more agile in matching interest rates with economic conditions.
Since the mid-1980s, prices have been largely stable. People born after 1960 have little memory of what inflation can do.
Although its role in battling inflation gets all of the attention, since the Great Depression the Fed has two mandates: promote stability in prices and promote the maximum sustainable employment.
The unemployment rate is currently at 4.6 percent, comfortable by historical standards, and slowly falling.
The Consumer Price Index, the most common measure of inflation, is at 3.5 percent, also comfortable historically. But it has been rising mostly due to a jump in energy prices.
"Over time, we know that price stability is the best way to get economic stability," said Diane Swonk, chief economist at Meisrow Financial.
She said the risk is that Bernanke will overshoot and raise interest rates too high. That would depress both inflation and employment. It is easy to err, she said, because interest policy is not a precision instrument.
"This is an incredibly blunt tool," Swonk said. "This isn't like laser surgery. It would best be thought of as a wooden knife."
Bernanke's style of communicating the Fed's orientation is almost diametrically opposite that of Greenspan, whose pronouncements often ranged from the ambiguous to the undecipherable. In contrast, Bernanke speaks a kind of bureaucratic English that is at least understandable.
Bernanke's efforts to be forthcoming backfired in April when he indicated to CNBC anchor Maria Bartiromo that the Fed might continue raising interest rates. The network broadcast the news, of course, and stocks fell.
"He wants to be as clear as possible in telling people what [the Fed is] going to do," said James McGibany, associate professor of economics at Marquette University. "He thinks this will mean less uncertainty for financial markets."
McGibany said Bernanke's message is clear to him.
"He is going to fight inflation first," McGibany said. "That will mean raising interest rates and slowing the economy down. ... It will be better for us in the long run."
Robert Manor writes for the Chicago Tribune.