Inflation Fears Cut Two Ways at the Fed

By JON HILSENRATH

The Federal Reserve's decisions to keep interest rates near zero and to flood the financial system with credit are sparking fears of an eventual outbreak of inflation.

But inside the Fed, an influential band of policy makers is fretting over the opposite: that the already-low rate of inflation is slowing further.

The heated debate at the Federal Reserve over whether if, and by how much, inflation is slowing will determine when the Fed decides to raise rates, Jon Hilsenrath reports.

The presidents of the New York and San Francisco regional Fed banks, William Dudley and Janet Yellen, see the abating inflation rate as convincing evidence the economy still is burdened by excess capacity and needs to be sustained by the Fed.

Others, led by Philadelphia Fed President Charles Plosser, argue that current inflation measures are distorted by an epic decline in housing costs and could mask a buildup of inflationary pressures.

This intensifying internal Fed debate over the behavior of inflation comes as the central bank plots an exit from an unprecedented experiment in easy money. Its read on inflation will influence how quickly it moves to raise short-term interest rates—which impacts everything from mortgage rates to new business costs to stock performance—and drain huge sums it pumped into the financial system during the recession. Recent developments have given the inflation-rate-is-dropping camp an upper hand.

In 2008, overall consumer prices actually fell for the first time in half a century, but then rebounded as energy prices stabilized. Over the past 12 months, the consumer-price index has risen 2.1%. But measures of inflation that strip out volatile energy and food prices are decelerating. Excluding food and energy, consumer prices in February were 1.3% higher than a year earlier. That was the smallest 12-month increase in six years, and well below year-over-year increases of above 2% before the recession.

"When unemployment is so high, wages and incomes tend to rise slowly, and producers and retailers have a hard time raising prices," Ms. Yellen, who is expected to be President Barack Obama's nominee to become the Fed's vice chairman, said in a speech last week. "That's the situation we're in today, and, as a result, underlying inflation pressures are already very low and trending downward."

Mr. Dudley made similar comments in comments in Lexington, Va., last week. "The substantial amount of slack in productive capacity that exists today will likely only be absorbed gradually. Consequently, trend inflation, at least over the near term, should remain very low."

In this camp, one worry is that inflation-adjusted interest rates—also known as real interest rates—could rise even if the Fed sits on its hands. Such a rise would be a disincentive for businesses to invest in new projects and for consumers to spend.

This unintended increase in rates could put a brake on the economic recovery.

The opposing camp believes the combination of low rates and more than $1 trillion the Fed has pumped into the financial system is a formula for inflation down the road. "As the economy improves and as lending picks up, the longer-term challenge we face will not be worrying about inflation being too low," Mr. Plosser said in an interview. "The risk is really to the upside of inflation over the next two to three years."

This camp focuses less on the amount of slack in the economy—the high unemployment rate and the number of empty office buildings, shopping malls and idle factories—and more on the risk that consumers and businesses will anticipate inflation and act accordingly. At the Fed's mid-March meeting, Thomas Hoenig, president of the Kansas City Fed, argued for an increase in short-term interest rates "soon" to "lower the risks of...an increase in long-run inflation expectations."

Surveys and bond price movements suggest Americans expect inflation of around 2% year-in and year-out, and Fed officials believe this helps keep the inflation rate stable. A change in inflation expectations in either direction could become important in Fed deliberations.

Mr. Plosser also argues that the recent decline in the inflation rate is a mirage, greatly influenced by an unusual decline in housing costs, which are heavily weighted in many price indexes. Excluding the cost of shelter, consumer prices were up 3.4% from a year earlier in February, pushed up in part by energy prices.

Excluding food, energy and housing, they were up 2.6% from a year ago. "I want to be careful not to read too much into one measure of inflation that is very influenced by housing," Mr. Plosser said.

Researchers at the San Francisco and New York Fed are scheduled to release a retort to this argument Monday that shows that among 50 different categories of consumer spending—from computers to hotels to jewelry—inflation rates have slowed over the past 18 months from the earlier trend.

The Fed has said it would keep short-term rates low for an "extended period," a phrase which means at least several months—as long as inflation is subdued, inflation expectations are stable and the economy is slack.

A persistent slowing of the inflation rate could push rate increases further into the future, possibly into 2011. But if officials dismiss recent data or if the pace of price increases accelerates, the Fed may boost rates before year-end.

Traders in futures markets anticipate the Fed will raise its benchmark federal-funds rate—which it has been holding near zero since December 2008—to 0.5% by November.

A wide range of companies recently have noted difficulty in trying to raise prices. General Electric Co., for instance, in a conference call with analysts, said prices of locomotive engines were falling because of excess supply. Speedway Motorsports Inc., which operates Nascar racetracks and drag strips, said it would reduce ticket prices between 4% and 5% this year.

"We have started to see a glimpse of the economy stabilizing," said Marcus Smith, Speedway's president. But he said he still had to fight hard to keep his customers.

"We're doing everything we can to make sure our existing customers are very happy. If they'll extend [contracts] this year for multi years we're willing to give better pricing and better terms."

But last week's Institute for Supply Management survey of factory managers found a rising fraction of respondents report paying higher prices for materials. In March, 53% said they were paying more—especially companies using petroleum products, wood and primary metals.

Although the consumer-price index gets more public attention, the Fed prefers another measure—the personal consumption expenditures index.

Excluding food and energy, it is up 1.3% from a year ago, and the slowdown is intensifying: Over the past three months, it has risen at an annual pace of just 0.5%, a slowdown that has been noticed by Fed officials. The Fed's preferred level for this measures is between 1.5% to 2%.