What Goes Down, Must Come Up?

IT'S ONE THING when consumers grumble about inflation--gasoline prices that are at previously unheard-of levels, food prices that have homemakers spiking their hamburgers with bread crumb. It's quite another when a troika of central bankers says it worries that inflation might be getting out of hand, that the genie they thought they had permanently bottled up is pressing hard on the cork in the bottle that entraps him.

European Central Bank boss Claude Trichet is dropping broad hints that he will finally act on his concerns and raise interest rates next month "to anchor inflation expectations." Bank of England Governor Mervyn King says "we are now facing a period of rising inflation." And the biggest gorilla in the international banking community, the chairman of our Federal Reserve Board, tells an audience in Massachusetts that "the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations."

If you think that the statements of the central bankers mean that peace prevails in international finance, think again. Bernanke hoped that his statement would shore up the dollar, which would ease oil prices because each dollar the producers received would be worth more. But Trichet's statement strengthened the euro against the dollar, causing more than a little consternation at the Fed and in the halls of the U.S. Treasury, both of which institutions are trying to talk up the dollar after a long period of hands-off-currency-markets.

Bernanke wanted to make certain that everyone got his message, so he pointedly added that the Fed "will strongly resist an erosion of longer-term inflation expectations," which for consumers means, "Don't count on cuts in mortgage rates or credit card charges," and for investors it means, "I will raise interest rates if prices continue to rise."

And well they might. Although core inflation (excludes food and energy) has been relatively tame, rising at an annual rate of 2.3 percent, inflationary expectations are formed by people who both eat and drive. They see inflation rising at a rate of 4.2 percent, eating into their purchasing power. And developing countries, which have been providing Wal-Mart with low-priced imports to keep consumers' costs down, are now finding that inflationary pressures are forcing them to raise prices. The Wall Street Journal reports that all 24 of the developing nations tracked by the Bank of America are failing to contain inflation within the bounds they have set for price increases. So when back-to-school time rolls around, consumers might find that the long decline in apparel prices has come to a screeching halt.

Unfortunately, the central bankers' inflation worries do not stem from a fear that the economies of Europe, the United Kingdom, and the United States are booming--indeed, over-heating. In fact, Europe's economy is slowing, the United Kingdom is about to reclaim the title of the sick man of Europe, and the United States...

Here the story is more complicated, which is why Bernanke devoted the bulk of his speech to telling the followers of his every word what he doesn't know. He isn't really sure of the effect of commodity prices and rising wages on inflation, and "there is much we do not understand about inflation expectations, their determination, and their implications." Not much reassurance there for those who think the Fed chairman's hand is firmly on the tiller, steering the economy between the twin shoals of inflation and recession.

But despair not. His knowledge might be imperfect, but his judgment seems fine. He has so far used all of the tools available, and invented new ones, to prevent the credit crunch from morphing into a major recession. And he believes that because of his aggressive interest rate cuts "the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so."

The latest retail sales figures, released after Bernanke's speech, support the Fed chairman's views. They came in at twice the increase analysts had been expecting, and earlier months' data were revised upward. It seems that more of the $56 billion in tax rebates distributed so far is ending in the tills of electronics and department stores than anyone anticipated--except perhaps the Bush team. "It's just amazing the American consumer's resilience in the face of everything negative," Stuart Hoffman, chief economist at PNC Financial told Bloomberg Television.