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The Honolulu Advertiser
Posted on: Wednesday, July 19, 2006

Interest rates pose dilemma for Fed

By William Neikirk
Chicago Tribune

WASHINGTON — Stagflation is a word invented by economists to describe a nasty economic mix — stagnation and rising inflation at the same time.

Stagflation was the curse of the 1970s, when double-digit inflation combined with anemic economic growth. It helped drive President Jimmy Carter from office and caused the Federal Reserve to push the economy into recession to deliver a knockout blow to inflation.

Stagflation could be returning, albeit in much milder form. The U.S. economy has begun to slow down after a roaring first quarter, while inflation is suddenly rising faster because energy and other commodity prices have been going up.

This is a condition causing the Federal Reserve, and its chairman, Ben Bernanke, to fret mightily over what its next step should be when it comes to interest rates. Americans will be looking for clues today when Bernanke gives his semiannual testimony to Congress.

"What we have is an introduction to stagflation," said Joel Naroff, an economic consultant in Holland, Pa. "It creates a real challenge for the Fed, which is a challenge for individuals and for the economy as a whole."

OUTSIDE A COMFORT ZONE

How Bernanke and the central bank respond has major implications for the economy and for the November election, especially incumbent Republicans who have been campaigning on a strong economy.

By raising interest rates again, some economists said, Bernanke would be needlessly risking a recession, since the central bank has boosted interest rates 17 times since June 14, 2004, and the economy is softening in response to these increases.

By pausing in its interest rate increases, other economists said, he could be risking a higher rate of inflation in the months ahead, requiring a tougher crackdown later that they say would certainly bring about a recession.

"It's the worst of all worlds if you are a central banker," said Ethan Harris, chief economist at Lehman Brothers Inc., with inflation just outside the Fed's "comfort zone" and the economy showing signs of softening.

He said the mild stagflation is a sign that the economy is in transition to slower growth. Inflation tends to rise toward the end of an economic expansion, but takes a while to subside when the economy slows down.

To Diane Swonk, chief economist at Chicago's Mesirow Financial, the numbers do not appear to indicate an extremely serious economic problem, although she and others worry that the Federal Reserve could overdo its response. Swonk said she believes the Fed will bring its interest rate increases to a halt at its next meeting on Aug. 8 while holding the door open for a rate increase in September.

It is clear that Bernanke, and the Federal Reserve's other members, are still uncertain about their next interest-rate move. For the new Fed chief, the August decision could be an extremely important one for his credibility in financial markets, where he is still viewed with suspicion.

Inflation at the consumer level has risen 4.2 percent in the past 12 months, but if food and energy prices are excluded, the "core" rate of inflation was 2.4 percent. The Fed focuses closely on the core rate.

But the Consumer Price Index for June will be released today, and could reflect a higher rate of inflation. Energy prices also are highly volatile, especially in the wake of the Middle East crisis.

Economic growth jumped strongly in the first quarter at a 5.6 percent annual rate, but all signs point to the belief that a slowdown is under way. Harris predicted a 2.5 percent growth rate in the last half of the year.