The Blog

Inflation Holiday

Understanding why Alan Greenspan raised interest rates, and where the economy is headed next.

12:00 AM, Jul 7, 2004 • By IRWIN M. STELZER
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ON SUNDAY, we Americans did what we always do on the Fourth: We grilled hot dogs and watched fireworks in celebration of the day in 1776 when we declared our independence of Britain by adopting "The Unanimous Declaration of The Thirteen United States of America." As Edmund Burke told the Parliament, "a succession of Acts of Tyranny" by the crown "was more than what ought to be endured." Then, as now, Americans were willing to wage war to unseat tyrants.

Americans have Iraq very much in mind, especially since we spent last week riveted to television images of a defiant Saddam Hussein telling a judge that Kuwait is part of Iraq. A further reminder of September 11 came when ground was broken for the new 1,776-foot tower in New York City (a height chosen to commemorate the break with Britain in 1776) that will replace the Twin Towers.

Fortunately for the president, 54 percent of Americans tell pollsters that the transfer of authority to the Iraqis will improve the situation in Iraq, and only 39 percent say the transfer will make things worse. Although a majority of Americans doubt that the administration has a plan for the reconstruction of Iraq, 66 percent tell CBS / New York Times pollsters that America should keep troops in Iraq "as long as it takes that country to become a stable democracy." That is about all of the good news the president can wring from recent polls, which suggest to everyone except the White House staff that the campaign is going badly.

PREOCCUPATION WITH IRAQ is only one reason that the decision of the Federal Reserve Board's Monetary Policy Committee to raise interest rates by 0.25 percent, from its 45-year low of 1 percent, hardly proved earthshaking, even though it represents a reversal of a four-year trend of ever-lower rates. The muted reaction consisted of cheers from pensioners dependent on interest earned on savings accounts; yawns from the majority of Americans--who have financed their home purchases with fixed-rate mortgages--and the markets, which had already priced in the long-anticipated increase; and concern from the inflation hawks who feel that Fed chairman Alan Greenspan is not moving hard and fast enough to nip inflation in its incipiency.

The hawks say that prices are rising at their fastest rate in four years, available excess capacity is disappearing, productivity growth is slowing, and unit labor costs are rising. Worse still, the items that consumers buy frequently--apparel, food, medications, and gas--have been rising at double-digit rates in the past year (butter up 23 percent, steak 17 percent, drugs used by the elderly, over 7 percent), while only infrequently purchased and therefore less-noticed items--such as used cars--are becoming cheaper. That has fueled inflationary expectations.

The hawks are also fretting because they see no end to the loose fiscal policy that has a profligate government spending more than it takes in as far ahead as the eye can see. They think that the Fed needs to tighten to offset the Bush administration's inflation-producing deficits.

BUT GREENSPAN is faced with highly ambiguous economic data. Absent a spurt that takes the core inflation rate significantly above its current 1.7 percent rate, he will be satisfied with small increments that in the next 18 months will bring rates to something like 4 percent. Most economists believe that rate is compatible with economic growth that produces neither unemployment nor inflation. Had the Fed raised rates sooner and faster, as the inflation hawks think best, it would have ignored a great deal of economic evidence.

The recent increase in inflation may be due to transitory phenomena such as the commodity price rises that are already slowing, and in some cases reversing, as the Chinese economy cools. And the economy may be slowing. The jobs report, issued just a few days after Greenspan's gradualism ruffled the hawks' feathers, suggests that Greenspan has got it right: Non-farm employment increased by only 112,000, about half of what the inflation hawks were predicting, and average hourly wages rose a mere 0.1 percent. Good news for bonds, bad news for Bush.