Inflation: The Latest US Import?

United States

April 20, 2007

By Richard Berner | New York

By any metric, US “core” inflation cooled significantly in March, renewing hopes for Fed ease and re-igniting risk appetite in global markets. Measured by the CPI, core inflation slowed to 2.5% in the year ended in March from 2.7% in February. Likewise, we estimate that measured by the core personal consumption price index (PCEPI) — the Fed’s preferred measure — core inflation slowed to just 2.1% in March. Both readings are fully 50 basis points (bp) below their peaks of last September, apparently putting inflation on track to come in at rates consistent with what the Fed deems to be price stability.

However, I think the March readings may represent a lull, and that some inflation risks are rising again. Like many other things these days, those risks are no longer entirely home grown; as in the 1970s, we may now be importing them from abroad. The upshot: Inflation has peaked, in my view, but there will continue to be flare-ups and the decline will still be gradual. Here’s why.

There’s no mistaking the decline in core inflation measured by the CPI over the past six months. While surging energy quotes drove up the headline rate to a 2.8% year/year gain in March — a seven-month high — the core rate decelerated to a ten-month low. Yet, three factors that depressed core prices in March were likely transitory, and all three may reverse in April. Seasonally adjusted hotel room rates plunged by 2.3%, as the actual increase failed by far to match the normal seasonal pre-vacation gains. Although such rates measured by the CPI rose just 1.3% from a year ago, hotel industry revenue per average room data suggest gains of 6-8%, so a rebound in the CPI version seems likely next month. Ditto for the 1% decline in apparel prices: This year they failed to match the normal increases accompanying the introduction of spring lines, and we suspect that a rebound is likely soon. Third, medical care goods quotes (mostly for prescription drugs) fell by 0.3% in March, marking the fourth decline in the last five months. With wholesale drug prices up by 3.5% in the last year, a rebound here also seems likely.

More important, several global factors seem likely to contribute to US inflation over the next few months. Among them: Strong global demand and limits on supply are boosting food and energy quotes. Energy quotes declined at an 11.5% annual rate in the three months ended in December, but jumped at a 22.9% annual clip in the three months ended in March. Food prices, meanwhile, have accelerated from a 2% annual rate in the September-December span to a 3.9% annual rate in the past three months. We believe that sellers typically pass some of these price hikes through to core prices with roughly a 2-4 month lag, via transport fares, some rents, and other goods and services. Just as the energy price declines of late last year may thus have modestly cooled core inflation in the past few months, so will the recent acceleration likely, if temporarily, refuel the core composite in coming months.

Perhaps more lasting, US consumer import prices are accelerating and the dollar’s recent decline may magnify their faster rise. Over the year ended in March, import prices for consumer goods other than motor vehicles and parts accelerated to 1.8%, the fastest pace in more than eleven years. The acceleration was broadly based, including in prescription drugs (from -0.9% to +2.5%, a 340 bp acceleration); toiletries and cosmetics (to 2.1%, a 200 bp swing); household goods (1.6%, a 140 bp swing); toys and sporting goods (up 140 bp to 1.4%). The dollar’s decline probably influenced that acceleration; over the past year, the Fed‘s broad, nominal trade-weighted dollar index declined by 3.4%. Not all of the dollar’s recent decline has yet shown up in quotes for imported goods, however. If the dollar continues to slide, especially against the Asian currencies and to some extent Europe, as we suspect, import prices likely will accelerate further, and add a tenth of a percent or two to consumer inflation.

Importantly, the slipping dollar isn’t the whole story. The boost to inflation from a weaker dollar has dwindled over the past two decades, reflecting weakening links between exchange rate changes and import prices and ultimately consumer prices. Several Fed economists in a paper last year found that the decline is a global phenomenon. Across G7 currencies, their work suggests that exchange rate pass-though to import prices has declined to 40% over the past 15 years from 70% in the 1970s and 1980s, and in the US, it has declined to only 30% (see Jane Ihrig et al. “Exchange-Rate Pass-through in the G7 Countries,” International Finance Discussion Paper 851, January 2006). That is, a 10% sustained depreciation in the dollar might, other things equal, boost the import price level by 3% over a 2-3 year period.

The empirical fact that such exchange-rate “pass-through” has apparently weakened over the past several years, like the flattening in the Phillips curve, may reflect good monetary policies. As well, it probably results from the globalization of markets and production that has promoted “pricing to market.” That is, exporters not wanting to surrender market share have more closely matched domestic-origin prices in setting their export prices in foreign currency, and they tend to hedge their currency risk either ‘naturally’ by sourcing abroad or financially. That probably muted the pass-through and lengthened the lags from currency moves to changes in relative prices long before the dollar began its descent.

Notwithstanding disinflationary monetary policy, I also suspect that the pass-through link varies with the cyclical state of the global economy and inflation expectations. Considering those factors, the weaker dollar may explain half the recent increase in import prices. And the booming global economy may have accounted for the other half, by increasing the pricing power of exporters to the US. Looking ahead, the combined effect of the dollar’s decline and the global boom on US inflation now could be larger than it was over 2002-04 (for more discussion, see “The Dollar and Inflation,” Global Economic Forum, May 5, 2006). The cyclical state of the domestic economy also matters for assessing the impact of all these global factors on US consumer price inflation. Despite the sluggish pace of US economic activity over the past year, the level of resource utilization is still high, and sellers may thus succeed in passing such price hikes through to consumer inflation.

Global factors — higher energy and import quotes and a weaker currency — may also contribute to US inflation by reviving inflation expectations. So far, however, there’s little sign of that: Inflation compensation measured by 10-year TIPs spreads plunged by 10 bp on this week’s good inflation news, to 240 bp. To be sure, the reaction in distant-forward breakevens was more muted, amounting to 3-4 bp, hinting that these developments haven’t much altered market participants’ underlying inflation expectations. In mild contrast, survey-based inflation expectations, such as the measure of 5-10 year expectations compiled by the University of Michigan ticked up to 3% in March. But it’s early days for assessing the impact of these developments on expectations.

The most important factor affecting inflation expectations is back home: The Fed. Clear goals and objectives and a straightforward sense of how the Fed will get there are both critical to anchoring longer-term inflation expectations. And by an large, the Fed has been successful in doing exactly that over the past several years. Lately, however, when the Fed says inflation is too high, market participants aren’t sure how to calibrate such statements. That’s partly because there has been some ambiguity over the Fed’s implicit inflation objective.

Officials have described their preferences in terms of a 1% to 2% “comfort zone” for core PCE inflation, but for three years, core PCEPI has run above the upper end of that zone. Many market participants thus assume that officials’ de facto target is 2% and not the 1½% mid-point of the “comfort zone.” If the Fed were clearer about this critical issue — whether they pick one or the other — I think it would more firmly anchor inflation expectations. Personally, I prefer 2%, because it builds in a bigger cushion for measurement error and disinflationary shocks (see “More Clarity, Less Guidance From the Fed,” Weekly International Briefing, March 30, 2007). Either way, together with a set of global factors potentially pushing up inflation expectations, lingering questions about the Fed’s objectives may translate into market uncertainty, pushing up term premiums and steepening the yield curve.

That steepening seems to be irregularly underway, and is becoming a popular trade. Some investors are assuming that the Fed now has a green light to ease and thus look for a bullish re-steepening. Fixed-income markets now discount a better-than-even chance of a cut by September for the first time in about a month. Don’t count on it: “Base effects” may cap year-on-year inflation for now, since comparisons with last spring are tough. But one month’s good inflation data won’t likely be sufficient to convince the Fed that the risks are balanced, and officials also may worry that global fundamentals are no longer disinflationary. Instead, the curve may steepen bearishly as term premiums rise and inflation prints turn a bit less favorable. Investors in that context should also consider TIPs. They’re more attractive now with some inflation upside, and seasonal “carry” is now relatively favorable (because TIPS are priced off the headline CPI before seasonal adjustment, and the seasonal upswing in gasoline and energy quotes is still underway). According to Morgan Stanley Interest Rate Strategist George Goncalves, 10-year TIPS are priced for a widening of about 12 basis points from current levels. I’m willing to bet that inflation surprises could easily take spreads higher.

There are risks in both directions, however. A rebound in inflation could quickly undermine today’s financial-market bullishness. The threat of protectionism could add another layer of risk to the inflation outlook, because it would block competition in US markets from cheaper overseas goods and services. Escalating protectionism, moreover, might extend and/or intensify the dollar’s recent decline. Perhaps the biggest irony in this context is that while many believe that globalization will be eternally disinflationary, courtesy of ever more tightly-integrated global supply chains and other global spillovers, globalization in these circumstances may have — at least for now — turned into an inflation tailwind.

Richard Berner

Inflation panic grips Fleet Street

23.04.2007

by John Stepek

It really is fascinating to watch how the Bank of England’s breach of what is, after all, a fairly arbitrary inflation target, suddenly has previously sanguine economic forecasters throughout the press shrieking for immediate action.

In fact, one of the biggest advocates of the “it’s different this time” theory, Times commentator Anatole Kaletsky, this morning calls for a half-point hike in interest rates next month to show that the Bank is serious about controlling inflation.This is from the man who continually berates and belittles the European Central Bank for keeping on raising interest rates, decrying the ECB’s rather stern line on money supply as old-fashioned.

It’s no surprise Mr Kaletsky is calling for tougher action - low or apparently non-existent inflation forms the basis of his “low rates forever” economic utopia. If inflation isn’t dead after all, then the Bank needs to take control right now before the pillars of debt propping up his dreams of a new era are kicked away.

Trouble is, it’s already too late...

So why is Anatole Kaletsky calling for a half-point interest rate rise next month? His arguments are sound enough.

He points out that some people would argue that the $2 pound should ease inflationary pressures in the economy, meaning the Bank can tread carefully on interest rates. But as he argues, the strength of the pound (remember, sterling was challenging the $2 mark just at the end of last year, so this isn’t a short-lived spike) should already have curbed inflation. The fact that it hasn’t “suggests that underlying inflationary pressures are much stronger than the Bank of England and the markets expect.”

Eventually, the spectre of soaring inflation would make sterling less, not more, attractive. This could lead to a sharp fall in the pound, thereby sending inflationary pressures even higher.

Much of this depends on whether the markets believe that Mervyn King and his colleagues on the Monetary Policy Committee really have any control over the UK economy. So Mr Kaletsky says that the Bank really needs to hike fast now, to safeguard its credibility.

It’s nice to see he’s finally caught up with reality - but the trouble is, it’s too late now. The time for half-point hikes was long ago - a half-point before Christmas, or in summer last year, for example, might have helped offset some of the pressure we’re seeing now. But the truth is, the Bank sealed the fate of the UK economy when it made that terribly timed, highly divisive decision to cut the base rate by a quarter point way back in August 2005, just as annual house price growth was on the verge of flattening.

That was the moment at which the Bank lost its credibility. Governor Mervyn King was outvoted, showing he didn’t have a handle on the rest of the MPC. Meanwhile, the markets, the population and anyone else who was watching realised that the real nature of the MPC was not to control inflation, but to avoid a recession like the plague. Just like its counterpart in the US, the British central bank had no intentions of spoiling the economic party; just like the Fed, the whole idea was “no recession under my watch.”

Eddie George, the former BoE governor, has already admitted that when he slashed rates to historic lows near the turn of the century, he was desperately trying to avoid a recession. He’s acknowledged that rates couldn’t possibly have stayed that low long term; but that this was a problem for his successors to deal with.

What no one seems to understand - or want to understand - is that the wider economy is not too different to running your household finances. If you spend more than you earn for a prolonged period of time, enjoying the good life while your household balance sheet hollows itself out (a period we shall call, for talk’s sake, a ‘boom’); then at some point in the future, you have to rebuild that balance sheet - start taking sandwiches to work, holiday in Sidcup rather than Sydney, take the kids out of Eton and send them to the local sink school (this period we shall describe as the ‘bust’).

The more profligate you were during the boom, the more thrifty you have to be during the bust - and clearly, the more painful the transition to a lower standard of living.

Here in the UK, we’re sitting on consumer debt of around £1.3 trillion. That’s some boom. And now we’re heading for the bust to match.

Just before we go, another argument in Mr Kaletsky’s piece is that the euro’s strength is more important to the strength of sterling than UK rates. If, he says, the ECB keeps hiking rates and the US economy keeps weakening (which he finds unlikely, but we believe is pretty much inevitable), then the euro will probably keep rising, and sterling with it - which could mean we see the pound hit levels as high as the $2.20 to $2.50 “that it occupied for most of the 1970s and early 1980s.”

We couldn’t help but be reminded of something he wrote only back in December, when the pound was challenging the $2 mark again. At that point, he argued blithely that the dollar was now the buying opportunity of the century – or at least the next 25 years.

In fact, we quote: “if [sterling] falls below $1.95, it has nowhere to go but down… if the pound tests the $2 barrier and then falters, it will be time to take a flutter, if not mortgage your house.” (You can read the original piece here: Demise of the dollar is greatly exaggerated.)

Sterling fell as low as below $1.93 in mid-January, and again at the start of March. We‘re hoping that no one literally staked the roof over their heads on a strong dollar.

Turning to the stock markets…

---

The FTSE 100 ended Friday 46 points higher, at 6,486, with support coming from miners and M&A targets such as Alliance Boots and Standard & Chartered. Mining stocks Xstrata, Lonmin and Vedanta Resources all benefited from the rising copper price. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 ended the day 109 points higher, at 5,938. In Frankfurt, the DAX-30 was 99 points higher, at 7,342.

On Wall Street, the Dow Jones ended the day at a fresh record closing high of 12,961, having added 153 points as the likes of Caterpillar reported expectation-beating results. The tech-heavy Nasdaq climbed 21 points, closing at 2,526, and the broader S&P 500 ended the day 13 points higher, at 1,484.

The Nikkei closed flat today at 17,455 - an increase of just 2 points - having fallen back from an earlier high of 17,656.

Crude oil had fallen back to $63.75 this morning, whilst Brent spot was 12c lower at $66.21.

Spot gold was little changed from its price in New York late on Friday, last trading at $691.90. Silver, meanwhile, was last quoted at $13.88/oz.

And in what is set to be the world's biggest-ever financial services takeover, Barclays agreed to buy Dutch bank ABN Amro Holding NV for 67bn euro today. However, ABN Amro may still receive a rival bid from Royal Bank of Scotland, Santander and Fortis, with whom it is meeting up today. Barclay's shares had risen by as much as 1.5% in London already today, whilst ABN Amro's were up 2.4% in Amsterdam.

And our two recommended articles for today...

What has the independent Bank of England given the UK?
- Ten years ago this May, the current Labour administration swept to power and announced operational independence for the Bank of England. Since then, the Bank has built up a reputation for inflation-busting. But one $2 pound and one explanatory letter to the Chancellor later, maybe it's time to reconsider. For Adrian Ash's analysis of what the Bank has done for Britain - and what it's likely to do next, click here: What has the independent Bank of England given the UK?

Why tourists are holidaying in hospitals
- With the growing popularity of medical tourism, a new generation of travellers is as likely to return home with a new hip as a tacky souvenir. In this MoneyWeek article, just available to non-subscribers, we pick three of the sector's fittest firms: Why tourists are holidaying in hospitals

URL

Euro hits new two-year high against dollar

Related
Wholesale prices up 1 percent in March

2 hours, 54 minutes ago

The euro surged on Friday to 1.3534 dollars, the highest level since January 3, 2005, on expectations of rising eurozone interest rates.

They added that the foreign exchange market was jittery ahead of a meeting of the Group of Seven (G7) financial chiefs in Washington on Friday, when the health of the global economy and the weakness of the yen are expected to be in focus.

The single currency later stood at 1.3521 dollars, compared with 1.3480 dollars in New York late on Thursday. The euro dipped to 160.06 yen after striking an overnight record of 160.87 against the Japanese unit.

The dollar meanwhile fell to 118.38 yen compared with 119.14 late on Thursday.

"The dollar has been depressed against the euro by the comments of (ECB) President (Jean-Claude) Trichet yesterday (Thursday) following the monetary policy meeting of the European Central Bank," said Paul Chertkow, head of global currency research at The Bank of Tokyo-Mitsubishi in London.

The euro had breached 1.35 dollars on Thursday after the ECB signalled that it was ready to raise eurozone borrowing costs again in June.

Trichet sent a clear signal that the bank was set to raise its key interest rates -- already at a five-and-a-half-year high -- still further in June, after holding rates at 3.75 percent on Thursday.

"Characterising monetary policy as still accommodative, he (Trichet) underpinned the expectation of another 0.25 point increase in the refinancing rate in the eurozone before mid-year," Chertkow added.

The euro has been buoyed in recent weeks by favourable interest rate differentials, analysts said.

In contrast with the ECB, the US Federal Reserve appeared to open the door to a cut in American borrowing costs last month as it kept rates unchanged at 5.25 percent.

Market players were cautious on Friday ahead of the G7 meeting amid speculation that the yen could become a topic of discussion, if only behind closed doors.

The weakening Japanese yen is causing consternation in European capitals, where finance chiefs are worried that the yen-euro exchange rate is penalising eurozone exporters.

"But the chances of strong remarks on a weak yen are very slim this time," said Tokyo-based Commerzbank analyst Ryohei Muramatsu.

"And since foreign exchange rates are stable in an orderly manner right now, there is no need for the G7 to say anything that may possibly disturb the market," he said.

Ahead of the G7 talks, the dollar could face further selling pressure from new data in the United States, with the latest US trade balance data and producer price inflation numbers due later Friday.

The euro was changing hands at 1.3521 dollars, against 1.3480 dollars late on Thursday, 160.06 yen (160.62), 0.6811 pounds (0.6812) and 1.6364 Swiss francs (1.6396).

The dollar stood at 118.38 yen (119.14) and 1.2101 Swiss francs (1.2167).

The pound was being traded at 1.9860 dollars (1.9785).

On the London Bullion Market, the price of gold pulled back to 677.25 dollars per ounce, from 678.50 dollars late on Thursday.

US central bank sounds inflation warning

The World Today - Thursday, 29 March , 2007 12:34:00
Reporter: Peter Ryan

ELEANOR HALL: The world's most powerful central banker has sounded a new warning about inflation in the United States and sparked concerns about interest rates.

The chairman of the US Federal Reserve, Ben Bernanke, said that while he's worried about the high-risk end of the US mortgage sector and that it could contribute to an economic slowdown, he regarded inflation as the greater threat to the global economy.

Economists say Mr Bernanke's comments on inflation suggest a cut in interest rates is now off the agenda.

And that has sent some investors on Wall Street running for the door.

More from our Business Editor Peter Ryan.

PETER RYAN: For Ben Bernanke, today's world is hardly one of economic stability, with rising oil prices, growing tensions with Iran, and almost daily volatile data usually sets hearts racing on Wall Street.

It's not much comfort, but there is one constant for central bankers - the ever-present "i" word or inflation.

BEN BERNANKE: Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to the upside.

In particular, upward pressure on inflation could materialise if final demand were to exceed the underlying productive capacity of the economy for sustained period.

PETER RYAN: Ben Bernanke was addressing a joint economic committee on Capitol Hill.

And he used the opportunity to reign in expectations stemming from last week's decision on interest rates that a rates cut was back on the agenda because of the softer language he was using on inflation.

But Mr Bernanke reinforced today's message on inflation with tougher words such as "risk" and "uncertainty".

And he added another touch of reality, confirming that the US economy, while not heading towards recession, is continuing to lose steam.

BEN BERNANKE: Economic growth in the United States has slowed in recent quarters, reflecting in part, the economy's transition from rapid rate of expansion experienced over the proceeding years to a more sustainable pace of growth.

PETER RYAN: Another factor, according to Ben Bernanke, is the continuing downturn in the US housing market, which has sent shockwaves through the overall economy, from building companies to the makers of building materials.

But at the moment, he says it's steady as she goes for the traditional mortgage market.

BEN BERNANKE: Mortgages to prime borrowers and fixed rate mortgages to all classes of borrowers continues to perform well with low rates of delinquency.

PETER RYAN: But it's the crisis in the sub prime mortgage sector - risky loans to borrowers with little or no credit history - that appears to be keeping Ben Bernanke awake at night.

BEN BERNANKE: To the downside, the correction in the housing market could turn out to be more severe than we currently expect.

Perhaps exacerbated by problems in the sub prime sector. Moreover we could see yet greater spill over from the weakness in housing to employment and consumer spending than has occurred thus far.

PETER RYAN: The mixed messages of a slowing economy, higher inflation, and little chance of a cut in interest rates despite the housing correction encouraged some investors to take their profits and run.

Wall Street closed in a gloomy mood, with the Dow Jones Industrial Average and the tech heavy Nasdaq both down 0.8 of 1 per cent.

And data earlier in the day showing that orders for durable goods rose less than expected last month, only underpinned the pessimism.

KEN MAYLAND: There really is a slow down going on in the industrial side of the economy and this is probably not the end, we're not at the end of it yet.

PETER RYAN: Ken Mayland is an economist and president of Clearview Economics in New York. He's also predicting tough times ahead for the US economy.

KEN MAYLAND: That's a bad signal, that's a sign that more production adjustments are necessary, so I think the next three, four months are going to be pretty tough slugging for the manufacturing side of the economy.

PETER RYAN: But it's the spiralling price of oil that continues to overshadow the global economic picture.

It's now up for the seventh day in a row - well above $US 64 a barrel - and the escalating concerns about Iran, particularly from Britain and the United States, could see the oil price remain volatile in the months to come.

ELEANOR HALL: Business Editor Peter Ryan.

Inflation Is Legalized Robbery,

Part 1
by Gregory Bresiger, Posted March 23, 2007

Part 1 | Part 2 [To be posted 3/26/2007]

Inflation. It’s the biggest problem in the world.

— Paul Cabot, legendary money manager quoted
in The Money Masters, by John Train.

A dangerous specter once again haunts our economy, our pocketbooks, and the value of almost every asset.

It is called inflation. And it is hurting us every day. It could also crush the hopes and dreams of millions of Americans engaged in any kind of spending, saving, or investment plans. That’s because our government, charged with curing or at least controlling it, is the source of the problem.

Given a proper understanding of what inflation is — it is the debasement of a fiat currency through the overprinting of money without any stated limits — there is only one party responsible: the government’s banking authority.

Yet few Americans seem to understand the origins of inflation. Others comprehend it but embrace limited or “comfortable inflation” as necessary for attaining a healthy economy. Over the course of centuries some have advocated the use of inflation as a way of redistributing income or as a way of paying for wars.

Inflation has always had an indisputable benefit for the governments playing this game, since few people understand what is happening until the policy has run amuck. Unfortunately, many of the most influential people in our society support a little inflation as a good thing. They argue that it keeps the nation out of depressions and sometimes provides a Robin Hood effect.

Like it or not, the cost of inflation is an economic disease that can mutate into a plague that destroys the economy. The plague has struck before, both here and in other countries around the globe over many centuries.

This disease hasn’t seemed so bad. And until recently there was a tendency to ignore it or minimize it. Still, one must ask: is persistent inflation — inflation that could get out of control at any time — a reasonable risk? Before one answers, let us examine the characteristics of our permanent inflation.

The sneakiest tax

Inflation is a tax because only the government creates money. This is why, I suspect, the people who support an aggressive foreign policy backed by big military establishments or an even bigger welfare state are usually the same people who minimize the danger of inflation or even defend it.

For example, after World War I, Weimar Germany, which continued and expanded many of the welfare programs of the pre-war state, used inflation without apology. Indeed, in 1922 Germany’s foreign minister, Walther Rathenau, argued that inflation “was no worse economically than controlling rents” and maintained it took only from those who had and gave to those who had not, which in a country as poor as Germany was “entirely proper.” Rathenau and others argued that once the inflationary spiral began, it couldn’t be stopped unless one was prepared for “revolution.”

But Italian economist Costantino Bresciani Turroni warned that relentless inflation would be fatal for the economy. It would wipe out “moral and intellectual values,” he wrote. Bresciani Turroni studied Weimar Germany’s inflation. He said it “poisoned the German people by spreading among all classes the spirit of speculation and by diverting them from proper and regular work.” We haven’t reached that inflationary phase in America today, but we feel its pull.

You don’t see the costs of inflation listed on a pay stub but its fearsome power eats away at your income. It is the sneakiest tax because most Americans don’t understand who or what causes it and why. Therefore, I believe, inflation is the greatest, most effective, form of robbery in history.

Exaggeration?

Hardly. Inflation, unlike armed robbery or stings perpetrated by flim-flam artists, is perfectly legal and acceptable as a tool used by governments throughout history. It is the ultimate con. Most of its victims have no idea that they’ve been hoodwinked with funny money. They have no idea that the government’s central bank uses inflation to steal from them even as they complain that retailers and others are charging what they believe are outrageous prices.

In the rare case when the average person understands what is happening, there are groups of politicians and endless eminent economists who rush to its defense. For instance, populist journalist William Greider, in his quasi history of the Fed, Secrets of the Temple, wrote of the benefits of the great inflation of the 1970s. That is when inflation rates were in the double digits.

“Inflation,” Greider enthused, “particularly benefited the broad middle class of families that owned their own homes, depended on wages for their income, not on interest and dividends from financial assets.” Of those economists whom Greider eulogizes, one thinks of John Maynard Keynes, who believed that inflation was needed to pull nations out of depressions. His followers became so numerous over the last 60 years that even a Keynesian critic such as Milton Friedman would say, “We’re all Keynesians now.”

Still, rarely will even the believers in controlled inflation, once the disease is no longer under control, blame the cause of this disease — our unaccountable central bank.

The Fed and inflation

In the popular press and in political speeches, high rates of inflation are usually not blamed on central bankers or the lawmakers who enable them. Private-sector concerns are usually blamed for high prices. The bogeymen must be found.

So high inflation rates have been blamed on the usual suspects. The suspects always include the oil companies, which several U.S senators wanted to nationalize back in the 1970s. Inflation also has been blamed on greedy Arabs (whose petrodollars were devalued by Richard Nixon) and on avaricious workers or capitalists who reap “obscene profits.” The latter is a political echo of the 1970s. It recently came back into fashion. A host of others, including members of various ethnic and religious groups, also are usually in the crosshairs of populist politicians whenever inflation rates rise.

Yet the responsibility for inflation lies squarely with the federal government, through its central bank, the Federal Reserve System. The Fed receives its delegated power from Congress. Its chairman is appointed by the president and confirmed by the Senate.

Some people believe that inflation can be managed for the benefit of the economy. Low rates of inflation, 2 percent or less a year, represent a kind of growth and price stability that prevents depressions, Keynesian economists have long held. They believe that a decline in prices and money wages (wages uncorrected for inflation) in bad times is politically impossible because of unions and the supposed failures of capitalism.

This 2-percent-or-less standard is the so-called comfort range that has been mentioned by various Fed officials. The Fed, unlike other central banks, sets no specific inflation targets. Nevertheless, this 1-to-2-percent inflation rate is the range in which central bankers believe they can manage the economy without excessive price increases but still achieve healthy economic growth, according to Janet Yellen, president of the San Francisco Fed.

To others, those I believe who have a greater skepticism of government management of the economy and a sense of history, this inflation-management idea is rot. Preventing disinflation and recession, while at the same time avoiding inflation rates that destroy buying power and harm long-term savers, is an impossible dream. Just look at where our economy is going today, these insightful critics warn.

In June, the Fed reported the highest price increases since 2002. In July, the annual increase in prices was recorded at 3.4 percent. In August, things got a little better when the monthly increase was recorded at 0.2 percent, which means the annual rate of price increases was now going at 2.4 percent. By any measure, the Fed is losing a dangerous game of inflation.

Inflation deception

But it is worse than that. The government’s Consumer Price Index (CPI) excludes the most volatile prices — food and energy — from its measurement.

This is tantamount to announcing that the federal deficit is X amount of dollars, not counting “off-budget” items, e.g., looming obligations such as Social Security and Medicare. Indeed, this explains how the Clinton administration wiped out the deficit, despite the fact that the federal debt continued to grow during its eight years. Between 1997 and 2001, a period when the federal government was proudly announcing a $557 billion surplus in the annual budgets, the federal debt increased by some $438 billion.

What happened?

It’s called off-budget accounting. This not-counting of unpleasant figures comes straight out of the Enron playbook.

So even when supposed low rates of price increases seem to be occurring, as in the 1990s, one should question government figures. After all, in effect, the government is providing us a report card on itself. And, whether it is Vietnam or Iraq or price-increase numbers, things always seem fine.

The government almost always gives a misleading picture of inflation. That is appropriate, since inflation always distorts the true value of goods and services. It confuses both sellers and consumers.

Although some defend a little inflation as a good thing, the exclusive government control of the money supply has had dire consequences for the saver, for the person on a fixed income, and for almost anyone planning to make a purchase in the distant future. It also creates a false wealth effect.

The classic inflation anomaly is the person who has more money than ever in his pocket or bank account but can’t maintain a decent lifestyle. Yes, this person has more nominal dollars. But he can’t buy as many goods or services as before because prices have gone up faster than ever before. This person feels richer — he has a greater number of dollars than ever before — but he is poorer, since his dollars command fewer goods and services.

For example, back in 1972, the average American had a weekly paycheck of $334.60, according to the U.S. Labor Department. Today, the average American makes more than that in nominal dollars (dollars that don’t reflect inflation rates). However, corrected for inflation, the average American today makes just $277.96.

The average American becomes frustrated. So he blames the messengers — the oil companies, employers, the retailers, et cetera — instead of the people responsible for setting and monitoring monetary and fiscal policy.

So given the latest skewed price numbers provided by the government, a simple truth should now be clear even to our central bankers and our lawmakers. They are on the verge of repeating the mistakes of the 1970s, the notorious era of stagflation.

Still, our central bankers, hoping not to upset fragile financial markets, recently decided, for now, not to raise interest rates, a politically popular move. However, some of these bankers have had second thoughts in public. Nevertheless they’re making a big bet with our property and the ability of tens of millions of Americans to achieve a happy lifestyle. Is it a good bet?

Part 1 | Part 2 [To be posted 3/26/2007]

Gregory Bresiger is a business writer living in Kew Gardens, New York. Send him email.