Wednesday, September 19, 2007

Did the Fed Lower Interest Rates Because of the Threat of Inflation?

The Federal Reserve lowered the fed funds rate and the discount rate by 0.5% each on Tuesday, September 18, 2007. The stock markets celebrated, with the Dow Jones Industrial Average jumping almost 336 points. Many commentators attributed the Fed action to the need to combat a slowing economy and the credit crunch in the financial markets.

However, the Fed's statement accompanying the interest rate cuts noted that the Fed "judges that some inflation risks remain" and that it would "continue to monitor inflation developments carefully." The Fed promised that it would "act as needed to foster price stability and sustainable economic growth."

A commitment to "foster price stability and sustainable economic growth" hardly reflects a pyromaniacal desire to light a fire under the economy. Indeed, the Fed stated that "[t]oday's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time." Moderate growth over time? That's worth a 336 point one-day jump in the Dow?

Let's consider the nonobvious. Perhaps inflation really did have something to do with the Fed's interest rate cuts. We'll put ourselves in the shoes of the Fed. Most of the Fed governors and the Fed's professional staff are economists, and economists love data. So we'll dive into some data.

Inflation is measured by assuming that an index of prices from a base time period starts with a value of 100. The Bureau of Labor Statistics (, which compiles the Consumer Price Index, uses 1982-1984 as the base time period. Price increases are incorporated into the base from time to time, and elevate its value. Price decreases are also incorporated into the base and push its value down. The Consumer Price Index for all Urban Consumers (CPI-U) is a commonly employed measure of inflation.

By August 2006, the value of the CPI-U had risen to a value of 203.9. This means that consumer prices, on the whole, had slightly more than doubled compared to the base period of 1982-1984. Then, a funny happened on the way to the Forum. The CPI-U fell. In September 2006, its value dropped to 202.9. In October 2006, its value fell further to 201.8. In November 2006, its value drooped even lower to 201.5. Only in December 2006 did consumer prices resume their upward march, moving up slightly to a value of 201.8. That, however, was still more than 1% lower than prices in August 2006. It was not until March 2007 that the CPI-U exceeded its value in August 2006.

The reason for this dip in the CPI-U was primarily due to the drop in oil and gasoline prices that began last August and continued into the fall. Gas was as high as $3.00 a gallon in the summer of 2006. By the late fall, it had fallen into the lower end of the $2 a gallon range. Such a dramatic price drop produced temporary deflation, a welcome but rare event.

Inflation is popularly measured from year to year. Most people don't care that, technically speaking, the value of the CPI-U was 208.299 in July 2007. What they care about is how fast consumer prices are rising annually. And that's the problem facing the Fed.

If consumer prices now simply stay level, the rate of inflation will increase this fall. That's because of last fall's price decreases. They will cause the difference between this year's price level and last year's level to increase, resulting in a higher inflation rate. This isn't just a statistical phenomenon. It is a reflection of the differences between real prices real people paid last fall and real prices real people face now. It depicts a true economic burden because people are no longer getting last fall's lower prices.

The cognoscenti among readers might note that the Fed prefers price indexes exclusive of food and energy costs (often called the "core" rate of inflation). Food and energy prices are sometimes volatile and create short-term upswings and downswings that wash out over time. Okay. If you look at the CPI-U excluding food and energy costs, you'll find a smaller, but similar trend. In August 2006, the CPI-U excluding food and energy costs was at 206.7. In September 2006, it rose to 207.2, and in October it rose again to 207.8. However, in November 2006, it dropped to 207.6 and in December 2006, it dropped again to 207.3. It would be in January 2007 that the CPI-U rose above its October 2006 peak. Thus, if the CPI-U excluding food and energy costs stays level this fall, the year-to-year change will increase. Again, we would see inflation rising.

It is doubtful that consumer prices, whether measured by the CPI-U or the CPI-U excluding food and energy prices, will stay flat this fall. Petroleum prices have recently reached an all time peak over $80 a barrel, and food prices keep rising relentlessly (up over 4% compared to last year). The core rate of inflation for producer prices revealed on Tuesday morning was 0.2% for August 2007, a disquieting figure. An increase in the rate of inflation this fall is virtually inevitable.

The Fed knows this. If they had waited to lower interest rates, or lowered them only a quarter point on Tuesday, the increase in inflation later this year could easily stymie an effort to lower interest rates later, even if the evidence began to show more clearly that the economy was headed for a recession. The Fed's reputation as an inflation fighter, which is crucial to its ability to stimulate the economy while keeping prices stable, would be mud if it cut rates in the face of rising inflation. Thus, it had to cut interest rates now, before the likely inflation statistics tied its hands.

It's unclear whether the economy will tip over into a recession. What's clear is that inflation will likely increase. By lower interest rates now, the Fed may have been trying to get ahead of the curve with respect to the economy. It almost surely was trying to get ahead of the curve of rising inflation.

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