Is the Fed unnecessarily scaring Stock Markets
Oct 10, 2005
The Wall Street Journal reported on Friday that three regional Federal Reserve Banks sent
shivers through markets by calling attention to the threat of inflation. These fears are grossly
exaggerated, and higher interest rates may cripple the economy.
Regarding inflation, two questions are key.
First, how much of recent energy price increases will work through to final nonenergy goods?
How much of that happened and happens in September and October will occur regardless of Fed
actions November 1. So far, very little pass through seems to have occurred. The producer price
index for final consumer goods, less energy, fell in August. Look at autos. It's not just the Big
Three that have been forced to trim prices but also the Japanese nameplates too.
Elsewhere, firms are going to face tough resistance to higher consumer prices. The producer
price data indicate large increases in commodities and more moderate increases in semifinished
goods and inputs to service providers (e.g., express delivery), but no inflation in final goods and
services. Producers have enjoyed very strong productivity increases in recent months, permitting
them to absorb somewhat higher material prices, and consumers have little additional cash to
spend on higher priced goods (consumer spending was already greater than disposable income
in July and August), and gasoline prices are draining their purses. Final goods inflation is what
matters, and that seem under control for reasons relating to both supply and demand.
Second, does any pass through of energy prices to nonenergy goods set off a self-perpetuating
spiral, or is the current burst, such as it is, a one time event? If it is a one time event, we are
going to get the burst of inflation we get, regardless of Fed actions November 1. It's too late to
affect those. Moreover, energy prices should recede as oil and gas and refining come back on
line in the Gulf, and inflation will abate regardless of what the Fed does. We simply have too
much competition in the marketplace, and labor markets show not sign of igniting a wage-price
The Fed is behaving as if we were in the 1970s, when union contracts would ignite wage-price
spirals--not so with an 8 percent private-sector unionization rate. Companies that still index
wages to inflation will contract very quickly, as other players in the marketplace eat their lunch.
Longer term, energy prices are going to be determined in global markets, and the Fed can do
little about those. If we pumped most of oil we use, oil were in short supply, and we could not
import additional supplies only at higher prices, the Fed would face a tradeoff between higher oil
prices and growth, and the Fed would have the option of dampening growth to stave off inflation.
Those days are long gone, and the Fed simply does not have that choice today.
The Fed is behaving as if it could affect energy prices and it can't. It is correct to worry about
inflation but in its thinking, the Fed has its feet planted firmly in the past.
With Katrina and Rita already sapping consumer confidence and consumers having little
additional money to accommodate higher gas prices, the economy is going to slow significantly
with or without Fed action. Raising interest rates at this juncture only risks throwing the economy
into a recession
All the Fed is accomplishing with its rhetoric is to panic the stock market. Will lower equity values
help inflation? I think not!