Smith Faculty Opinion Article - October 7, 2005

Is the Fed Unnecessarily Scaring Stock Markets?
By Dr. Peter Morici, Professor of International Business

The Wall Street Journal reported this morning 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 spiral.

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!