Whether the troubles in the credit and financial markets will do more than slow the growth of the "real" economy is the subject of considerable debate. The economy grew at an annual rate of a healthy 4 percent in the second quarter, driven by an 11.1 percent jump in business investment, but that was before recent upsets in financial markets. Last month sales of durable goods rose by a healthy 5.9 percent, but other indicators suggest consumers are starting to rein in their spending. The unemployment rate has been a low 4.6 percent, but that was before the lay-offs in the financial services and residential construction industries were tallied. Banks' balance sheets seem healthy, but the markdowns in the value of some of the dicier assets have not yet been factored in. World growth has been robust and driven U.S. exports, but that was before the problems in German, UK, and other financial markets made themselves felt, and before the Chinese authorities decided to put their foot on the brakes with a bit more force.
Some analysts are convinced that unless the Federal Reserve Board's monetary policy committee cuts interest rates no later than its September 18 meeting--sooner would make nervous Wall Streeters happier--the economy will lapse into recession. The Fed is listening: Chairman Ben Bernanke says he is "prepared to act as needed."
But the Fed has to worry about two things. First, Bernanke does not want to send a signal to the markets that no matter how imprudent its lenders might have been, he will bail them out. That would create what economists call "moral hazard." Second, he has to consider whether a cut in interest rates might add to inflationary pressures. Core inflation--excluding food and energy--is tame. But include those items--people do eat and do drive--and the situation becomes complicated. The original reason for excluding food and energy was that prices of those commodities tended to be volatile, making monthly changes unrevealing of underlying trends. But that was then and this is now. We might not be witnessing volatility, but a long-term upward trend in oil and food prices. The OPEC cartel has learned to gear its members' output to the level of crude and petrol inventories, putting a floor under prices at a time when production is not keeping pace with demand.
And food prices are now reflecting the decision of several governments to convert corn and other products to petrol in the tank rather than food on the table. This creates a new source of demand, which will drive food prices up, at least until supply can catch up.
Bernanke knows all of this. He knows, too, that an unnecessary cut in rates would scupper his anti-inflation policy, and a too-long delayed reduction will tip the economy into recession. So he will have a somewhat more fraught Labor Day weekend than the vast majority of satisfied-with-life Americans. But my guess is that in the end he will take comfort from Friday's report that incomes and spending are rising at a rate that suggests the economy will grow nicely for the rest of the year, with inflation at unworrying levels, and conclude that his current policy is just about right.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).