Inflation Fears May Curtail Fed's Rate-Cut Flexibility - WSJ

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Includes: AGG, DIA, QQQ, SPY
by: Judith Levy

Many investors, unnerved by the triple threat of a manufacturing slowdown, a decline in job growth and a credit crunch, are hoping for more aggressive rate-cutting by the Fed. They take as their model the economic slowdown of 2001, when the Fed intervened freely to ease monetary policy. But 2008 is not 2001, Greg Ip argues in Friday's Wall Street Journal -- a point underscored by this week's dramatic surges in the prices of oil and gold. Nor does the Fed's view of the economy tally with that of Wall Street. The Fed agrees with most market participants that recession is a genuine threat, but maintains that inflation is a greater risk today than it was seven years ago -- meaning it has less flexibility than it did then to take steps to avoid recession. Alan Greenspan, who was Chairman of the Fed in 2001, concurs. "This is a much tougher monetary-policy environment than anything I experienced," he said.

As far as inflationary risks are concerned, oil is Exhibit A. The oil price hit $100 a barrel this week, up about $40 in a year. That surge pushed up the 12-month overall inflation rate to 4.3% in November. In 2001, oil was about $30 a barrel prior to 9/11, and inflation was 1.6% at year-end. An additional red flag is the "potential growth" rate, defined as the "speed at which the economy could grow without bumping up against capacity constraints." That figure, which was 3.4% in 2001, is now 2.5%, implying a greater danger of "inflationary bottlenecks."

Some market observers take issue with the Fed's priorities. "I see little chance of the kind of wage-price spiral that has set off inflation in the past," said former Treasury Secretary Larry Summers. "If I'm wrong and [easier monetary policy] creates undue inflation pressures, they can be removed gradually at a moment of much less financial peril." The question is, how easy would it be to get the inflation genie back in the bottle? "If...the economy bounces back...and inflation remains elevated, then if monetary policy is very aggressive now, you might find yourself in a terribly inflation-risky environment later next year," said Federal Reserve Bank of Philadelphia President Charles Plosser -- and efforts to rein in inflation expectations "might prove to be costly."

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