Behind Cheaper Credit, Inflation Fears Loom

By Steven Mufson
Washington Post Staff Writer
Wednesday, March 19, 2008

The Federal Reserve Board's rate cut yesterday increased the chances that months of Fed moves could start to trickle down to homeowners in time to ease the pain when adjustable-rate mortgages reset this year. And people who borrow money to pay tuition, buy cars or cover unpaid credit card bills might eventually see some benefit.

But the Fed's action could also revive inflation, many economists fear. By reducing the interest rate financial institutions charge each other for short-term loans, the Fed makes money more readily and cheaply available. If it miscalculates, it can pump too much money into the economy, fueling excessive demand for goods, housing and capital spending -- and driving up prices.

That would undermine Fed Chairman Ben S. Bernanke's long-cherished notion of setting a low, narrow and predictable target range for inflation. Through higher consumer prices, all Americans would effectively help pay for the rescue of the financial industry. The decline in housing prices might be tempered, but inflation would eat away at real housing values.

"The good news is that this will take pressure off of housing prices," said Kenneth Rogoff, an economics professor at Harvard University. "The bad news is that it will be very painful to squeeze the inflation out of the system when this mess is all over."

The threat of inflation was evident in commodity markets yesterday. Though at historically high levels, prices for corn and copper rose on the expectation that the Fed rate cut would breathe new life into the economy and avert a drop in demand. Oil prices jumped more than $3 in New York to $109.42 a barrel.

Commodity price hikes could translate into higher prices at gas stations and grocery stores. Airlines will be less likely to get relief. Yesterday Delta Air Lines offered voluntary severance payouts to about 30,000 employees, more than half its workforce, as it restructures to adapt to high jet fuel prices, among other problems it faces.

The Labor Department reported that the producer price index for finished goods rose 0.3 percent on a seasonally adjusted basis in February after a 1 percent increase the previous month. Food prices fell last month, while prices for consumer products, automobiles, prescription drugs and other goods rose.

Whatever the potential inflation trade-offs, the Fed apparently felt they were worth it to help key sectors of the flagging economy. For big banks borrowing billions of dollars a night for routine financing, manufacturers exporting goods to Europe and anxious investors, the three-quarter-point interest rate cut was a welcome shot in the arm.

Many companies will benefit because the Fed cut is also likely to keep the dollar weak. That is one way the central bank's action bolsters the economy because it makes U.S. goods more competitive and can further trim the nation's enormous trade deficit.

That's good for companies like Caterpillar, maker of engines, turbines and construction and mining equipment. Last year, Caterpillar's exports from the United States jumped 20 percent to $12.7 billion, or 28 percent of the company's $45 billion in revenue.

There is also strong demand for Caterpillar products from abroad because high commodity prices are swelling the coffers of such countries as Brazil. "Most of the commodities, a lot of the oil and gas, a lot of the minerals, are coming out of emerging markets, creating terrific positive balance of payments for them," Caterpillar chief executive Jim Owens told analysts last week.

The potential benefits for U.S. exporters weren't enough to win support for rate cuts from leading inflation hawks. Lee Hoskins, former president of the Federal Reserve Bank of Cleveland, co-wrote a Forbes magazine piece that compared the current economy with that of the 1970s.

"The Fed has abandoned the one thing it can truly control -- the long-run increase in price levels -- in a self-defeating attempt to keep the economy growing," he wrote. "Creating more dollar bills will not add to the nation's wealth, or make workers more productive."

Other economists said the Fed had to cut rates to steady the financial system.

N. Gregory Mankiw, a Harvard economics professor and author of a popular economics textbook, said: "We don't have good textbook answers for how you deal with a collapsing investment bank. Dealing with Bear Stearns going from $100 a share to $2 . . . is not something we have good off-the-shelf answers for."

Other analysts said the Fed cut rates to head off foreclosures on adjustable-rate mortgages. Many homeowners signed mortgages with very low introductory rates that will reset to market rates this year and next, forcing homeowners to make sharply higher monthly payments.

"The Fed is obviously bending over backward to help minimize payment shock for buyers whose mortgages would have reset to substantially higher rates," said a former mortgage trader for one of the major investment banks.

But whether the Fed action will actually lower mortgage rates isn't a sure thing. So far they haven't fallen as sharply as Fed rates. According to Mortgage Information Services, 30-year fixed-rate mortgages were 6.34 percent on average last September when the Fed began to cut its rates. The 30-year fixed-rate mortgage stayed flat for a few weeks, dropped to 5.48 percent in late January, then climbed again to 6.13 percent last week.

Some analysts worried that this could be a symptom of what is often called "pushing on a string," a phrase that describes the lack of impact the Fed sometimes has on consumer rates when financial institutions remain cautious about loans.

But Mankiw said the Fed still has plenty of tools to boost the economy and room to cut rates. "I don't think we're in a position where monetary policy is not effective," he said.

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