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Soaring prices threaten economy

Inflation can undo antirecession effort

Email|Print|Single Page| Text size + By Robert Gavin
Globe Staff / February 21, 2008

Consumer prices rose sharply last month and oil prices hit a record above $100 a barrel yesterday, fueling inflationary pressures that could complicate efforts to steer the US economy away from recession.

Despite a weakening economy that many analysts, including Federal Reserve chairman Ben S. Benanke, say should put a damper on inflation, prices have kept rising at a worrisome pace. Over the past three months, inflation has surged at an annual rate of nearly 7 percent, more than double the pace in the previous three months, the Labor Department said yesterday.

Fueling the surge are energy costs, which have soared at a 44 percent annual rate since November, according to the Labor Department.

"We've got a rock-and-a-hard-place problem if inflation is setting in," said Larry Chorn, chief economist at Platts, a publisher of energy market information.

The problem is that the Fed is trying to revive the struggling economy by aggressively cutting interest rates. Rate cuts are meant to encourage consumers and businesses to borrow and spend, which can create enough demand for goods and services to raise prices. If the Fed maintains low rates when prices are rising, the central bank risks setting off a period of even higher inflation.

On the other hand, if the Fed fails to cut rates fast enough and far enough, the economy could slide into recession and experience a longer and deeper downturn.

The Fed faced such a dilemma in the 1970s, when policy makers kept interest rates low in the face of soaring energy prices and a struggling economy. The United States settled into a period of stagnant economic growth and double-digit inflation, which gave rise to the term "stagflation." Ultimately, the Fed, under then-chairman Paul Volcker, cured inflation by pushing its benchmark interest rate to 20 percent. Mortgage and other borrowing rates climbed, causing a deep recession in the early 1980s.

Currently, the Fed's benchmark interest rate stands at 3 percent. The Fed has cut the rate 2.25 percentage points since September, including 1.25 percentage points last month.

As the '70s experience shows, economists said, the Fed must remain vigilant about inflation. If prices continue their rise, that could force the Fed to stop cutting rates - even at the risk of a prolonged slowdown. Some Fed officials have raised concerns that the central bank could overlook inflation in its zeal to prevent a recession.

In a speech yesterday, retiring St. Louis Fed president William Poole warned, "The seeds of an inflation problem are sown several years in advance, and it is not always easy to see the seeds as they sprout."

For the time being, though, the Fed appears ready to continue to cut rates, betting the economic slowdown will reduce demand and ease price pressures. Economists expect policy makers to cut the benchmark another half point, to 2.5 percent, when they meet next month. That would be the lowest rate in three years.

"Right now, the Fed can't abandon the weak economy and problems in financial markets, even though inflation is kind of sizzling," said Diane Swonk, chief economist of Mesirow Financial, a Chicago investment firm. The Fed is "acting on a hope and wish that inflation will ease with the slowdown."

Soaring energy costs have been the key inflation driver. Yesterday, oil prices continued their run, closing at a record $100.74 per barrel on the New York Mercantile Exchange. The recent run-up was sparked by a variety of supply concerns, as rebels attacked oil facilities in Nigeria; Venezuelan President Hugo Chávez threatened to cut off the United States from his country's oil; and members of the Organization of Petroleum Exporting Countries suggested the cartel could cut production.

Rising energy costs pose a thorny problem for economic policy makers because higher prices fuel inflation and stymie growth at the same time. Higher energy prices act like a tax, taking away money consumers could otherwise spend on goods and services. In Massachusetts, gasoline prices are 34 percent higher than they were a year ago, and heating oil prices are 39 percent higher.

High energy costs could also blunt the impact of the federal stimulus bill, which will send rebate checks of $300 to $1,200, in some cases more, to individuals, couples, and families. If oil prices stay at $100 a barrel, gasoline prices could rise to $4 a gallon, sucking about $100 billion from the US economy - about the same amount as the stimulus would put into consumers' hands, said Mark Zandi, chief economist at Moody's Economy.com of West Chester, Pa.

"Nothing's more difficult than rising oil prices," Zandi said. "They undermine growth and raise inflation, and there's no good policy response to that."

Robert Gavin can be reached at rgavin@globe.com.


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