Fed's rate-raising is aimed at a ghost of 1970s inflation

THE BALTIMORE SUN

THE inflation myth just entered its 27th incarnation after Federal Reserve policy-makers apparently saw their janitor wearing a rhinestone jumpsuit and singing "Suspicious Minds."

New inflation fears, as expressed by the Fed, have hurt stocks, raised interest rates and presumably unnerved consumers. But runaway inflation is simply not a risk these days. The economy just proved it by weathering the biggest set of inflation-creating forces since the 1970s with barely a ripple.

Inflation, like Elvis, is still dead.

Suppose I told you, a decade or two ago, that in the early 21st century the United States would go to war and its budget would careen from balanced to a nearly half-trillion-dollar deficit. What if I said the money supply would swell in late 2001 at more than three times its historical growth rate?

What if you knew oil prices would triple over two years and the dollar would plunge close to 30-year lows against the currencies of major trading partners, putting upward pressure on import prices?

You'd sell stocks and bonds and head for Montana. Betty Crocker couldn't create a better inflation recipe. Similar factors spawned 10 percent and 12 percent annual increases in the Consumer Price Index in the 1970s.

But this time, the perfect inflation recipe has produced something less like a souffle and more like a pancake.

The Consumer Price Index rose only 3.5 percent for the 12 months that ended in November. A percentage point of that gain came from September through November as oil headed to $56 a barrel, but oil has since fallen back toward $45.

Is that the best you can do, inflation? After all the huffing and puffing? Fact is, the economy just passed a critical inflation stress test. If we don't have killer inflation now, we're not going to get it anytime soon.

In the 1970s union workers got big wage increases, which were passed to consumers as higher prices. Baby boomers were entering the work force, which drove up demand for consumer goods, and the rise of two-earner households created extra disposable income that could afford the rising prices.

Those factors, mainly on the demand side, don't exist now. Many baby boomers are nearing retirement, and almost all consumers are buried in debt, crimping their ability to spend. Raises and jobs are scarce. Nobody pays full price. We're the discount nation; even Wal-Mart has trouble raising prices these days.

But the biggest change is on the supply side. Global competition and the decline of trade barriers give U.S. consumers access to seemingly limitless supplies of inexpensive goods and labor. And the Internet furnishes a devastatingly precise means to sift through them for the best deals.

International trade made up only 7 percent of the U.S. economy in 1975. These days it's nearly a fourth, meaning the economy is much more open and inflation pressures get dispersed beyond our borders before they have a chance to build up.

The Heckscher-Ohlin theory predicts that, as international trade grows, prices for labor, goods and other production factors will decline in places where they are relatively high and rise in countries where they are relatively low. That's what is happening. The United States is the "high" country, and growing world commerce is restraining growth in our costs and prices. (And our salaries.)

Inflation bugs will have two retorts.

First, they'll note that the consumer price figures given above may understate true inflation, partly because the government does a bad job measuring housing prices, which have gone bonkers.

Second, they'll point out that the big oil-price increases and main dollar decline occurred relatively recently and that their full effect on consumer prices might not have arrived yet.

Those are good points. But neither of them make a case for troublesome, long-term inflation or for a more aggressive Fed, which has already raised short-term rates five times since mid-2004.

Economist Milton Friedman defined inflation as too much money chasing too few goods. In the United States these days we have the opposite.

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