Inflation Now Enemy No. 1 for Fed

With hardly a pause for reflection, central bankers, markets and economic commentators are casting aside angst that the housing bust and credit crunch might cause another Great Depression and are turning instead to inflation anxiety. It's easy to see why. It's easy to overdo it. In the U.S., higher prices for energy and food have pushed consumer prices up 4.2% over last year, a return to the pace of the early 1990s. Producer prices are up a startling 7.2%. In Europe, inflation is running at 3.7%, the highest in the European Central Bank's short life. In Britain, consumer prices are 3.3% ahead of last year. The Bank of England anticipates inflation will top 4% in the second half and remain "markedly above" its 2% target into 2009. In many emerging markets, inflation is worse: 10.5% in Saudi Arabia, 10.4% in South Africa, 7.7% in China. Headlines scream "whiff of stagflation," recalling the painful combination of sluggish growth and rising prices that plagued the 1970s. Central banks toughen anti-inflation rhetoric and raise rates, or prepare to do so. Federal Reserve Chairman Ben Bernanke vows that the Fed "will strongly resist an erosion of longer-term inflation expectations." Finance ministers from the Group of Eight major economies, preoccupied when they met just few months ago with financial-market and banking woes, last week emphasized "global inflationary pressure." In one sense, the fact that central bankers are fretting about inflation is a relief. It means they're less worried that the U.S. housing mess has brought the world dangerously close to the abyss of financial disaster. It's really hard to have a depression and rising prices simultaneously. From the Fed's vantage point, the U.S. economy is doing better than officials feared a few months ago. Although the triple whammy of rising oil prices, falling home prices and a continuing credit crunch pose significant "downside risks," in the Fed's parlance, the U.S. economy kept growing, perhaps feebly, through the current quarter. And rising oil prices and an upward creep in consumer prices, though challenges, are familiar issues to seasoned central bankers and their staffs; the credit crisis was uncomfortably novel. In the midst of it, U.S. Treasury Secretary Henry Paulson recalled the words of an investment-banking client confronting a hostile takeover: "This would be interesting if it wasn't happening to me." Inflation is up primarily because energy and food prices are up so much. Yes, that has spilled over to prices for airline tickets and overnight package delivery. (Fed Ex said Wednesday that U.S. revenue per package increased 9% because of increased "fuel surcharges" and higher charges per pound; package volume declined 3%.) But the rest of the U.S. economy hasn't yet caught the inflation virus. Excluding food and energy prices, the consumer price index is up 2.3%, not much different from the past couple years. That's no comfort to those of us who eat, drive and use electricity daily. It does mean that if energy and food prices stop rising and stick at today's elevated levels, the headline inflation rate will fall abruptly. So far, U.S. wages haven't started climbing faster despite rising prices and inflation headlines. The Fed's strategy is to make sure they don't. It is, essentially, trying to keep enough slack in the economy so prices outside energy and food don't take off. One reason the ECB sounds harsher than the Fed is that the pace of European wage increases has begun to pick up, a hint of what central bankers dub the "second-round effects" of oil-price increases. "It doesn't necessarily imply second-round effects are materializing, but is indicative of intensifying domestic inflation pressures," ECB No. 2 Lucas Papademos told reporters recently while visiting South Korea. Ben Bernanke, a student of economic history, knows that today's conditions are a long way from the Great Inflation of the 1970s. (The annual reported increase in the CPI went from 1.07% in January 1965 to a peak 13.7% in March 1980, and didn't drop below 4% until 1983.) But he also knows that the Great Inflation occurred because the Fed badly misunderstood what was happening in the economy and kept interest rates too low and because consumers and businesses expected inflation and acted accordingly. He wants to avoid the second -- the dreaded increase in "inflation expectations" -- by loudly assuring everyone that the Bernanke Fed knows its history. For much of the past year, Mr. Bernanke has demonstrated that he is determined to avoid a repeat of the Fed mistakes of the 1920s and 1930s that contributed to the Great Depression. He still is. But he also is mindful of the Fed mistakes of the 1970s that contributed to the Great Inflation, and wants you to know that he is determined to avoid those as well.