Tue, May 29, 2001 page21

• Inflation watch begins in US as interest rates fall

  ECONOMY Although the US Fed chairman hinted interest-rate cuts would continue, investors are starting to wonder if Alan Greenspan is going too far

  • By Art Pine / BLOOMBERG
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  There's a growing dichotomy between the Federal Reserve and US investors over how big a threat inflation has become, and whether the nation's central bank is paying enough attention to it.

  The disparity is widening. Fed Chairman Alan Greenspan said last week that policy makers still regard weak growth as the major risk and hinted he would continue to lower interest rates.

  Greenspan discounted suggestions that inflation was mounting.

  Government inflation gauges show prices, particularly for energy and services, are beginning to speed up, and trading in financial markets suggests that investors are worried the Fed has cut rates too much.

  "We count eight ways that the markets are saying that inflation is a problem" and that the Fed "has overdone the easing," said James Bianco, head of Bianco Research LLC in Barrington, Illinois.

  Bianco cites financial indicators from the decline in bond prices to the performance of Treasury inflation-protected securities. The markets have "grown unhappy" with Fed policy, he said.

  The gap between the Fed and the markets could become serious.

  Expectations play an "essential role" in "containing price pressures and promoting growth," Greenspan said.

  "Any evident tendency in financial markets or in household and business attitudes for such expectations to trend higher would need to factor importantly into our policy decisions," he told the Economic Club of New York on Thursday.

  Yet, the Fed chairman hinted that interest-rate cuts would continue and the central bank has been expanding the money supply at almost a 9 percent rate, a pace that some economists say is almost certain to intensify inflation pressures.

  "The danger is that this will result in a prolonged period of stagflation," or sluggish economic growth that's continually held back by high inflation, as happened during the 1970s, said Paul Kasriel, economist at the Northern Trust Company in Chicago.

  Moreover, recent figures show that inflation is picking up. While labor market pressures have eased, the consumer price index has been rising, led by accelerating costs for energy, housing and health care. So far this year, the CPI has increased at a 3.8 percent annual rate, compared to a 2.8 percent rise for all of last year. The so-called core CPI, which excludes food and energy, has risen at a 3.3 rate so far, up from 2.6 percent for all of 2000.

  Even the government's core personal consumption expenditures price index -- which Greenspan has cited as one that he watches closely -- is worsening. It rose at a 2.6 percent annual rate in the first quarter, compared to 1.6 percent at the end of 2000, Kasriel said.

  "It really is a concern," said Joel Popkin, a former Bureau of Labor Statistics inflation-watcher who now runs his own consulting firm here. "There are others, too. Communications equipment is going up. Airline fares are apt to rise."

  Greenspan dismisses such worries. ``With energy prices probably peaking and the easing of tightness in labor markets expected to damp wage increases, prices seem likely to be contained,'' he said. He also said gasoline prices will ebb.

  Investors aren't buying the chairman's assurances, Bianco said. He lists eight separate financial measures that he contends show that investors expect inflation to worsen and are worried about the Fed's plans to continue cutting rates. Among them:

  -- Long-term interest rates, as measured by the Moody's Aaa corporate bond index, have been climbing since the Fed announced its latest rate reduction on May 15. This is the first time in history that long-term rates have risen during a prolonged period of Fed rate cuts, Bianco says.

  -- Short-term interest rates, which typically plunge when the Fed lowers rates, also have been edging up. That happened during the early 1980s, Bianco said. However at that time yields on two-year notes were near 15 percent and half-percentage-point rate cuts were commonplace.

  -- The so-called ``break-even inflation rate'' for inflation-linked Treasury securities, which repre-sents the market's view of the long-term inflation picture, has risen almost 70 basis points since the Fed began cutting, signaling expectations of higher inflation.

  At the same time, Bianco said, other indicators are suggesting that the markets have been assuming that the Fed won't cut rates much further:

  -- The yield curve that marks the spread between the two-note and the Fed's target interest rate on overnight loans between banks steepened on May 15 for the first time in 16 months. That's saying "the Fed has done enough," Bianco said.

  -- Fed funds futures contracts predict the Fed will cut the overnight rate by a quarter percentage point.

  Greenspan noted the disparity between his views and those of investors. He said, however, that "forecasts of the suppression or re-emergence of inflation, like all forecasts, do not have an enviable record."

  His own track record isn't flawless, yet Greenspan's assessment may be prevailing. While Fed Governor Laurence Meyer warned that policy makers will have to "calibrate" their rate cuts to keep inflation in mind, he didn't call for a halt.

  The consequences could be serious, says Ira Kaminow, an economist at the Capital Insights Group. Greenspan is "taking a bigger risk with inflation down the road.
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