Alan's perilous poker game By Ian Campbell UNITED PRESS INTERNATIONAL | March 25, 2005 http://www.wpherald.com/storyview.php?StoryID=20050325-042017-7171r WASHINGTON -- Two numbers. The U.S. inflation rate. The U.S. short- term interest rate, as set by the Federal Reserve. This week both went up and made headlines. Everything in the world economy depends on them as the poker game Fed Chairman Alan Greenspan has played for five years draws near at last to its perilous outcome. What has Alan's bold gamble been? After the U.S. stock market plummeted in the first quarter of 2000, ending the golden age -- fools' gold? -- of the 1990s, and the U.S. economy slipped towards recession in 2001, Greenspan began to slash the Fed Funds interest rate that he controls, taking it to just 1 percent. This level was well below the inflation rate and therefore "negative," in economists' terms. In effect, Greenspan made money super cheap. You could buy it for very little -- for the interest rate is the price of money. But the danger of making money cheap is that you devalue it, for abundant money may pull inflation up, reducing the value of money. Is inflation the danger newly confronting Greenspan, as the markets fear? The story is more complicated than that. In the first place the consumer price inflation that popped up this week in the February inflation report is still not so high, despite this week's alarming headline number: a 0.6 percent rise in consumer prices in February. Annualize that increase -- assume it occurred every month for 12 months -- and you would have a disastrously high inflation rate of 7.4 percent. But the headline February number exaggerates the current level of consumer price inflation in the U.S. economy. Seasonal adjustment of the February CPI increase brings it down to 0.4 percent -- and that follows increases of just 0.1 percent in January and zero in December. The current annual inflation rate, in the 12 months to February, is a not-too-bad 3 percent. That number comes down to 2.4 percent if you take volatile food and energy prices out of the equation. For energy prices, inflation in the past year is 10.4 percent. Record high oil and natural gas prices play a big part in a rise in U.S. consumer price inflation that is still quite modest; and energy prices must surely fall as winter gives way to spring. There is another factor that ought to have pushed up inflation considerably and in fact has not done so by much. The decline in the dollar against other major currencies means that the prices of imported goods have tended to rise. Friday March 18 the Bureau of Labor Statistics reported that import prices in the United States rose by 0.8 percent in February, following a rise of 0.7 percent in January. The annual increase in import prices is now 6.1 percent. But the bulk of this is oil-related. Excluding petroleum products, annual inflation in import prices is 2.9 percent -- again, remarkably modest given the extent of the dollar's decline. So Alan's big gamble is working, is it? The economy is growing and inflation has not gone up too much. Cheap money has done no harm -- and perhaps a lot of good, ending recession, averting the threat of a prolonged downturn. Is this how we should see things? The problem Greenspan has is that his deliberately inflationary policies -- intended to avert deflation -- are beginning to demonstrate why they are risky. U.S. economic growth has continued to exceed that in Europe, but devaluation of money and inflation are present in the U.S. economy. The devaluation is in the dollar, worth far less than it was. The inflation is in house prices, which have been rising fast because of ultra-cheap credit. And now there is some inflation in consumer prices. Why? Because the growth and demand that Greenspan has successfully fostered have created what economists call "pricing power." Companies find that they can increase their prices without losing customers. And they do so, pushing prices up. The Fed referred to this in the statement it issued Tuesday after increasing the short-term Fed Funds interest rate to 2.75 percent. "Pressures on inflation have picked up in recent months and pricing power is more evident," the Fed said. The Fed's statement balanced this by saying, on no particular grounds, that "longer-term inflation expectations remain well contained," but the markets have rightly drawn the conclusion that the Fed is going to keep raising U.S. interest rates in order to prevent inflation rising higher. Which raises the vital question of what will happen to growth. In the most recent quarter, the fourth of 2004, U.S. growth was running at 3.8 percent, almost five times the European pace, almost eight times faster than Japan's. But two fuels were feeding the fire of U.S. growth: cheap money, and the liberal fiscal policy of George W. Bush, with taxes cut and expenditure raised simultaneously. Now both Alan and George are obliged to stop pouring fuel so liberally onto the fire. Will that bring growth to a halt? Many think not. Listen to this commentary from the economists of the Mortgage Bankers Association: "It hardly seems time to throw in the towel on the current economic expansion. Thanks to dramatic increases in home prices and solid gains in equities, households have enjoyed increases in net worth during the past couple of years matching those of the late 1990s." "Solid gains in equities" -- just like those, no doubt, that occurred in the late 1990s. And "dramatic increases in home prices." It is by this frothy inflation in asset prices, fostered by Alan's cheap money, that U.S. economic growth is underpinned. The danger is therefore huge as Greenspan takes out his interest rate pin to burst the first signs of consumer price inflation. For pricking the incipient bubble in consumer prices may also burst the huge one in house prices and the not small one in stock prices. The deflationary pressures that surged through the U.S. economy in 2001 after the stock bubble burst in 2000 are going to do so again. But this time round the deflationary waves will be multiple and bigger: falling house prices, falling stock prices, and a government that is so heavily in deficit that it cannot, this time, afford to pour money into the economy. It looks like we will know the result of Alan's double or quits gamble late this year or early next one. When he gets up from the poker table, don't expect anyone to be smiling. -- (Global View is a freelance column reflecting on issues of importance for the global economy. Comments to [EMAIL PROTECTED]) ------------------------ Yahoo! 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