Fed's Contradictions are Roiling the Markets

There are times when the best thing the Federal Reserve Board chairman can do is say as little as possible. This is one of those times.

The financial markets are volatile enough, with global jitters over terrorism, oil prices surging to unprecedented highs and the specter of a nuclear Iran threatening to interrupt fuel supplies. But Fed Chairman Ben S. Bernanke’s conflicting statements about the economy and inflation have only made things worse.

One moment Bernanke hints the Fed may pause its interest-rate hikes, then he says inflation is really not that bad and, now, this week, he raises new concerns it may be worse than he previously believed.

Bernanke came into the chairmanship promising a clearer picture of the Fed’s thinking, but that promise has turned into a topsy-turvy roller-coaster ride of contradictory public statements that have agitated the stock markets and left investors increasingly anxious about their financial future.

Monday’s near-200-point drop in the Dow Jones industrial average was the latest example of what Bernanke has wrought in the short time he has been at the Fed’s helm. He has left many investors longing for the days of former Fed chief Alan Greenspan, whose murky microanalysis of economic matters was often so opaque no one could be sure what he meant.

There are a number of reasons I think Bernanke and the Fed are overemphasizing the threat of inflation and in danger of sandbagging an economy that remains strong.

The first is the inflation-measuring yardstick. It is woefully outdated and often excludes price-deflating movements in the economy as a result of cost-savings technologies, higher productivity that has lowered per-unit production costs, a competitive global economy whose imports have held prices down here and a revolution in downsizing that has cut overhead while boosting sales, profits and reinvestment.

Average consumers have seen prices plummet on products once beyond their reach — from cell phones to desktop computers, telecommunications costs to generic drugs. It’s a long and growing list but one not fully included in the government’s inflation basket.

Bernanke says the core inflation rate, which excludes volatile energy prices, is running between 2.3 % and 3 %, above the Fed’s 1 % to 2 % target. I think the core rate is closer to the Fed target and, even if a bit higher, tends to be absorbed in a massive $12 trillion economy.

And what exactly has so frightened the Fed into hammering the economy with much higher interest rates?

Unemployment is a low 4.6 % as a result of 5.3 million new jobs created in the last three years. But wages edged up by less than 0.1 % in May, hardly a sign that labor costs were rising at an excessive rate that could worsen inflation.

Productivity, inflation’s worst enemy, rose by a robust annual rate of 3.7 % in the first quarter. Personal incomes were up 6.7 % in the month of April. Industrial production rose 4.7 % in the past year.

Corporate earnings on the whole have been spectacular. U.S. exports have been brisk. The economy came roaring out of the first three months of 2006 with a vibrant growth rate of 5.3 %, but with its core inflation rate remaining within modest bounds.

While there are signs the economy may be cooling off a little, which is, after all, what the Fed wants, this economy is not remotely in any danger of tanking. That is, unless the Fed overshoots in its zealous and misdirected drive to slow growth.

What Bernanke never seems to acknowledge — and what the Fed may be ignoring — is the free market’s self-correcting mechanisms to keep the economy from overheating and to keep inflation in check.

Rising oil prices certainly are an additional cost, much like the Fed’s interest-rate hikes, but fuel prices are effectively applying the brakes to an economy that appears to be gently slowing down.

Higher fuel bills tend to get passed on in the costs of everything we buy or absorbed by businesses attempting to keep their prices competitive enough to keep their customers coming back.

But the overlooked story of the oil-price surge is that it has not appreciably dampened economic growth — yet. For the most part, the U.S. economy has absorbed the higher costs, often offsetting them with cost-cutting elsewhere in the means of production, distribution and marketing.

Take the airline business, for example. Gloom-and-doom analysts have long been predicting that higher fuel costs were going to sack the industry. The airlines have certainly struggled since 9/11 brought airline travel to a near halt, but right now higher fuel prices haven’t dampened air travel.

"With a record 207 million passengers expected to fly this summer, the airline industry is on track for one of its best periods in years," writes columnist Keith Alexander in Tuesday’s Washington Post.

This economy is a lot stronger than the bears give it credit for, but is it strong enough to withstand further Fed pounding?