Washington policymakers don't often admit that they might be wrong. Yet that has been the noteworthy message from the some of the Federal Reserve's biggest brains in recent weeks.
Fed Chairman Alan Greenspan said last week that he and his central bank colleagues believe that "inflationary pressures are not likely to be a serious concern in the period ahead." And so, they think it "very likely" that they can raise interest rates slowly "over the quarters ahead." But before investors could reach for their party hats, the chairman cautioned that "forecasts are subject to error," and if the Fed's judgment "turns out to be mistaken, we will change."
That followed the admission two weeks earlier by Donald L. Kohn, a Fed governor and 34-year veteran of the central bank system, that "there is much about the inflation process that we do not understand, and I have been surprised at the extent of the pickup in core inflation this year. . . . Given our limited understanding of price determination, we must keep a close watch on actual inflation outcomes."
So if these two don't know exactly how inflation works, how could anybody else? That's exactly the uncertainty plaguing the financial markets as analysts and traders debate whether the Fed has correctly gauged the inflation pressures appearing in pockets of the economy. If Greenspan & Co. are right, the recent spurt in consumer prices is largely temporary -- reflecting factors such as the surges in oil and food prices. But if they are wrong, more widespread inflation will take off -- fueled by a growing economy, rising employment and interest rates that are inappropriately low. And as Fed officials have broadcast loudly, if they discover they have erred, they will raise rates as aggressively as necessary to keep the inflation genie in the bottle.
While the cork appears secure at the moment, some observers -- and perhaps some Fed officials -- think they see some wisps of smoke leaking out. Businesses are raising prices, not just for oil- and food-related items, but also for housing, apparel, medical care, education and hotel rooms.
And much of the recent spike in oil prices has reflected fears of supply disruptions, caused by turmoil in the Middle East, that appear unlikely to fade soon. Greenspan frequently mentions "geopolitical tensions" and the possibility of other terrorist attacks as clouds still hovering over the economy. More broadly, as he said Tuesday, "uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape."
That said, Fed officials do believe inflation tends to rise when the economy is in overdrive, the job market is tight and long-term inflation expectations run high. In the current economy, that means inflation should not be a problem for a while. But if they have miscalculated, they will have to move rates up higher or faster than they would have otherwise to keep that cork in place.
-- Nell Henderson