WASHINGTON—Conventional wisdom has long held that a hot economy and rising energy prices spark inflation that must be quelled by interest-rate increases to slow economic activity.
But a growing number of thinkers now believe that free trade and global competition are taming inflation by limiting businesses' ability to pass along rising costs and that interest rate hikes may not be as necessary as they were in the past.
If they're right, it means that the Federal Reserve's aggressive attack on inflation, with 17 straight interest-rate hikes between June `04 and June `06, may have been overkill, slowing the economy, particularly the vital housing sector, more than was necessary.
Inflation is the measure of rising prices across the economy. Think of it as the financial equivalent of termites eating away the spending power of your paycheck. Inflation reached a post-World War II high of 13.5 percent in 1980, before Federal Reserve Chairman Paul Volcker used aggressive rate hikes to subdue it. The rate increases sent the U.S. economy into its worst recession since the 1930s but ultimately wrung out inflation.
Surging oil prices now threaten to reignite inflation. The 30-month run-up in global oil prices, from $29 a barrel in February 2004 to more than $70 a barrel today, drove consumer-price inflation to 4.1 percent over the 12 months ending in July. That's the highest it's been since 1991.
To contain inflation, the Fed began raising its benchmark interest rate in June 2004. But after 17 hikes, the Fed's rate-setting panel took no action on Aug. 8, leaving the benchmark rate at 5.25 percent, even though nearly every measure of inflation remained above the Fed's comfort zone of 1 percent to 2 percent annual growth.
Why stop?
The Fed said the risk of inflation appeared to be shrinking. Economic growth had slowed to a 2.5 percent annual rate from April to June, down from a sizzling 5.6 percent rate from January through March. That alone reduced inflationary pressure. The Fed also wanted to pause to gauge the effects of the rate hikes because they affect the economy only after a lag.
But there's more to the story.
Fed Vice Chairman Donald Kohn told bankers in June that the dynamics of inflation are changing due to the increasing integration of U.S. business in the global economy, and the rise of China and India.
Kohn acknowledged that traditional inflation measures may be dated and that free trade and global competition may be doing some of the work previously done by interest rate hikes. But just how much of a brake globalization is placing on U.S. inflation is impossible to measure.
"Unfortunately, huge gaps and puzzles remain in our analysis and empirical testing related to these effects," Kohn said.
"The Fed understands that it doesn't understand," said Ed Yardeni, chief strategist for Oak Associates, an investment fund manager in Akron, Ohio. "What a lot of policymakers and macroeconomists may be missing here is the world is becoming increasingly influenced, at the microeconomic level, by competition. Free trade is the globalization of competition."
And competition limits the pricing power of companies.
In the late 1970s, when oil producers withheld product, oil prices soared and sent inflationary waves across the economy. Businesses raced to pass along their rising prices and wages rose to keep pace. The result was an inflationary wage-price spiral upward.
Today, there's no such wage-price spiral, despite the run-up in oil prices. Businesses increasingly face global competitors, no longer just local or national ones. That limits their ability to raise prices even as their costs go up. And that, in turn, keeps pressure on wage growth.
"Over the last 20 years, workers have felt tremendous pressure from globalization, felt job insecurity, seen much slower increases in real wages than the general growth of the economy," said Kenneth Rogoff, a Harvard University economist who was among the first to recognize the changing dynamics of global inflation. "I don't particularly view that as a wonderful development, but it's one of the reasons it's been easier ... to control inflation."
Another reason? China, India and other emerging economies with high-tech production and low wages have lowered the global cost of manufactured goods. Another? Ever more sophisticated technology is powering rising U.S. productivity, a worker's output per hour, which has helped offset rising energy and commodity prices.
In fact, core inflation—omitting volatile food and energy prices—remains lower than the so-called headline inflation felt by consumers. Core inflation is a better measure of the economy's overall price trends.
"Core inflation rates remain worldwide around 2 percent. That's really quite extraordinary," said Yardeni of Oak Associates. "It's just an indication that despite this huge increase in the price of energy, which impacts the cost of doing business, very little has been passed on. What better excuse can you have for raising your prices?"
Yet globalization's anti-inflation benefits could prove transitory, warned Mark Zandi, chief economist of Moody's Economy.com, a consultancy in West Chester, Pa. Wages are rising in China, he said, and the Chinese government is increasingly reluctant to shield its manufacturers from rising energy prices through price controls.
"Most of their cost structure is now rising," Zandi said. "This very powerful weight on global inflation is lifting, and it is no longer the constraint on goods' prices."
Fed Chairman Ben Bernanke is scheduled to discuss global economic integration at the Fed's annual seminar this Friday at Jackson Hole, Wyo. He and his colleagues will decide what to do next about interest rates on Sept. 18.
Critics, such as Sen. Jim Bunning, R-Ky., argue that Bernanke's been putting economic expansion at risk by using rate hikes to combat an inflation threat that doesn't exist.
"Bernanke is acting like a bad doctor who over-prescribes a lethal dose of medication to a patient who is not sick," the senator said in a statement last month.
But former Fed Chairman Volcker defended Bernanke in July on Bloomberg television. He noted that inflation threats are harder to measure in today's globalized economy than when he was fighting it in the late `70s and `80s.
"While the economic situation was much worse, it was easier to act because it was clear what the enemy was," he said.
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(c) 2006, McClatchy-Tribune Information Services.
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