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Clouds in a 'Healthy' Economy

April 24, 2005

Inflation is surging, wages are flat, all sorts of deficits are exploding -- how do we sleep at night? Just imagine how we'd feel if the economy weren't doing reasonably well.

Is that underlying reality of a healthy economy about to change? It's an unsettling question, and one that is getting harder to answer. Hence the return in recent weeks of gut-wrenching volatility on Wall Street. The stock market cares little about the past. It strives to predict where the economy is headed, and watching the latest back and forth between bulls and bears is like watching a ballgame in which the lead keeps changing.

Alan Greenspan must be more worried than he is letting on. Thursday, the Federal Reserve chairman soothed the markets while testifying before a Senate committee, but he was awfully testy when asked about his previous support for the Bush tax cuts. A central banker in the twilight of his career, Greenspan is eager to distance himself from this administration's disastrous economic stewardship.

Yes, he agreed tax cuts were warranted, he argues, but only if the surpluses -- remember those promised surpluses? -- had held up. "They didn't listen to all of what I was saying," the Fed chief said, hopeful that history will absolve him.

The administration's reckless deficits are making Greenspan's job rather difficult these days, so he is understandably bitter, if not contrite. The Federal Reserve is trying to control inflation without slowing economic growth -- a tough assignment any time you have soaring fuel and commodity prices combined with consumer unease. One reason Washington's fiscal folly makes the Fed's job even tougher is that global disapproval of the nation's economic mismanagement drives down the value of the dollar, and for a nation as hooked on imports as we are, a depreciating currency contributes mightily to inflation.

The Fed's predicament is acute, as it runs the risk of falling behind the curve in fighting inflation. The Fed has been gradually raising its key short-term interest rate, which banks use when borrowing overnight funds, to an annualized 2.75%.

Rates were at historical lows not long ago because the Fed feared deflation and wanted to stimulate consumer spending by making money cheap. But inflation, as measured by the consumer price index, soared to a monthly increase of 0.6% in March. Rising oil prices were part of the explanation, but not all -- inflation was still 0.4% for the month with changes in oil and food prices factored out. That translates to a much higher-than-anticipated 4.8% annual rate.

The Fed, which next meets May 3 to consider monetary policy, will have to continue raising interest rates, maybe even more abruptly than it would have liked, to address this inflation, at the risk of dampening economic growth. Wages are not keeping up with inflation, and consumers, who account for roughly two-thirds of all economic activity, are already feeling a need to rein in their spending.

Higher interest rates could further distress people, especially in households with adjustable-interest debts. And if higher rates derail the stock market or pop what looks increasingly like a bubble in housing prices, and people start seeing their wealth erode, consumer sentiment will turn even gloomier.

All that said, worrying about 1970s-like stagflation, that perfect storm of high inflation and low growth, does seem a bit premature. The economy is still growing at a sound rate, corporate profits reported last week were reassuringly strong and new data show an uptick in manufacturing and a drop in new jobless claims.

Trouble is, economic news is never purely good or bad anymore.

High gasoline prices, for instance, encourage conservation and exploration. A tightening labor market could improve the living standards of working families by raising wages, but would also boost inflation, forcing the Federal Reserve to hike rates more forcefully, which could pop the housing bubble, which could .... .

Once again, how do we sleep at night?

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