New Fed boss must be bold in combating inflation

June 09, 2006|By MICHAEL J. MARSHALL

WASHINGTON -- Newly minted Federal Reserve Chairman Ben S. Bernanke came out swinging this week against inflation, with strong comments that his Fed is determined not to have recent rises in commodity and energy prices passed through to everyday prices.

"The best way to prevent [that]," Mr. Bernanke said, "is by anchoring the public's long-term inflation expectations."

While possessing strong inflation-fighting credentials as an academic and member of the Federal Reserve Board before taking over the chairmanship in January, this may have been the closest thing to a tacit admission that he missed his first opportunity in May to establish his bona fides as an inflation hawk and, more important, to signal markets that his Fed would not allow inflation to establish itself with too much force.

At its May 10 meeting, the Fed raised its short-term interest rate target by one-fourth of a point to 5 percent, its 16th consecutive such move in as many meetings. But it was a predictable action that likely had little impact on inflation fears.

Two weeks later, Mr. Bernanke assured members of a Senate committee that inflation was a serious concern to him and the Fed.

But a sharper increase at the meeting May 10 might have given Mr. Bernanke his sea legs after just a few months on the job, without the need for rhetorical confirmations. A decisive surprise move at this month's Fed meeting might give expectations the jolt they need.

Although off recent highs, several forward-looking indicators, including the price of gold and other commodities and Treasury bonds linked to inflation expectations, have been signaling inflation ahead, even if backward-looking data have not shown these higher costs being passed on easily to consumers.

The reasons for those commodity price moves may be as important as the moves themselves, which is why the Fed will continue to look for more information that reveals whether the pass-through to consumers is indeed happening. Indeed, some of the rise in commodity prices could be mere speculation in an uncertain political world.

Nevertheless, it is expectations of inflation, as much as inflation itself, that affect economic behavior. And it is expectations of inflation that the Fed needs to manage. Once the expectations creep too high, they are harder to get out of the market psychology. The chairman's comments Monday suggest he believes that strongly.

But his actions will undoubtedly speak louder than words.

When the Fed meets late this month, it needs to think seriously about raising rates not another quarter-point, but perhaps one-half or even three-fourths of a point if need be. Getting to where the Fed is going on rates faster may help suppress doubts that inflation will remain tame. A bigger rate increase might also allow the markets to look forward rather than in the rearview mirror.

The post-9/11 and post-Hurricane Katrina Fed under Chairman Alan Greenspan had cut rates to negligible levels. All of this was important as a short-term stimulus and was justified, given the shocks that those events were (and could have been) to the economy on several levels.

With historically low rates, the cost of borrowing was so diminished that investors and consumers plowed ahead even amid economic uncertainties. While the Fed delivered several half-point moves on the way down, the trip up has been slower. It takes months before cuts have a real impact on the economy.

No Fed wants to get blamed for causing a recession, but the alternative to not raising rates aggressively enough may be the same or worse if inflation gathers steam. In fact, the easy-money policy could be one of the significant factors behind the commodity rise - including the cost of a barrel of oil, linked to our rising gas prices, which many fear will stall the economy.

The Fed manages expectations by occasionally surprising the market. Its most effective policy tool is the ability to deliver the unexpected in order to drive fears out of the system forcefully. Baby steps may feel nice, but they may not get us where we need to be quickly enough or deliver much of a message.

Perhaps the slight pullback in gold and commodities prices in recent days, as well as a slight rebound in the dollar, signals the Fed should worry more about hurting the economy or the consumer than about inflation.

Or perhaps it is saying the market already expects the Fed to get aggressive at its next meeting and is prepared to take its tough medicine.

That's the judgment Mr. Bernanke will have to make.

Michael J. Marshall, an adviser to former Sen. Bob Dole, studied economics and public policy at Georgetown University. His e-mail is michael.marshall@alston.com.

Columnists Clarence Page and Trudy Rubin will return Tuesday.

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