Inflation Alert

By GERALD P. O'DRISCOLL JR.

The 1970s was a decade of stagflation -- the concurrence of a rising inflation rate and stagnant economic growth. The U.S. economy has not now reached the double-digit inflation rate (almost 15% by 1981), or the 9% unemployment rate, experienced back then. But the early '70s, not the decade's end, offer the more ominous parallels to today's situation.

With "headline" consumer price inflation (CPI) at 4.3% for the last 12 months, we have now reached the inflation rate that spurred Richard Nixon to impose wage and price controls on Aug. 15, 1971. The controls were certainly the wrong remedy, but the intuition that such a high inflation rate cannot long be tolerated was correct.

Nixon acted because the inflation rate, though declining, remained stubbornly above 4%. What has changed to render 4% inflation tolerable today?

Nothing for those who earn, spend and save the dollar. What is different today is that the Fed now takes food and energy prices out of the inflation measure and instead reports what it calls "core inflation." Thus we're told inflation is only 2.7%.

The original rationale to exclude food was that the Fed should not try to offset weather-induced supply shocks. Energy prices were also excluded because the Fed decided it should not try to offset OPEC-induced supply shocks. The Fed wanted an inflation measure that excluded temporary changes and focused on persistent movements. But arbitrarily excluding major components is not the accepted way to remove volatility, and there is a lively debate among economists within the Fed on alternative techniques. Regardless of the outcome of that technical exercise, the core inflation measure has become a misleading statistic at best. The global food trade mitigates the effects of localized weather events. Rising energy prices are not the effects of one-time supply shocks, but the systematic result of global demand.

Dollar users do not experience "core" inflation. What people purchase every day is precisely what is excluded from the core measure. For parents with growing children, milk, eggs and bread are not optional purchases. For millions of Americans, especially in the West, a long daily commute by car is a reality.

The Bush administration and its supporters have long pondered why it has not received credit for good economic policies. Perhaps this is in part because the benefit of tax cuts has been offset by rising energy prices, and now rising food prices.

The use of the core rate has lulled both the administration and the Fed into complacency, disconnecting them from the experience of ordinary consumers. Until recently, inflation doves pointed to the flat yield curve (long-term interest rates close to short-term ones) to buttress their case that inflation and inflationary expectations are low. But the bond market was slow to pick up on the new era of inflation in the 1970s. Not until 1974-75 did the long-bond yield and the yield curve finally flash an inflation warning signal. From July 1974 to May 1975, the Fed funds/long bond yield spread went from negative 466 basis points to a positive 300 basis points.

Economists Manuel H. Johnson and Robert E. Keleher found that only in late 1977 and early 1978 were "all the key market price indicators [commodity prices, exchange rates and bond yields]" signaling "a significant deterioration of the value of money."

The bond market was late to the game in the 1970s and may once again be a lagging indicator. The retirement savings of millions are meanwhile gradually being confiscated.

The Federal Reserve now confronts a serious economic problem with limited scope for action. Asset prices, especially those linked to housing, are falling. Financial institutions are capital-constrained and risk-averse, and are not lending. Economic growth is flagging. The classic response would be first to reflate the banking system and then the economy. But current inflation is rising. Excess money creation will translate quickly into even higher inflation.

Yet Fed Chairman Ben Bernanke has in recent days promised further interest-rate cuts and monetary largesse. San Francisco Fed President Janet Yellen promised the Fed will tighten later at the right moment -- easier said than done. Charles Plosser, Philadelphia Fed president, was closer to the mark when he recently said "once the public loses confidence in the Fed's commitment to price stability, it is very costly to the economy for the Fed to regain that confidence."

The Fed needs to return to its mandate of controlling inflation. The first step is for the Fed to shed an inflation measure that misleads itself, other policy makers, and the markets. We do not need a rerun of the 1970s. Once is enough.

Mr. O'Driscoll, a senior fellow at the Cato Institute, was formerly vice president of the Federal Reserve Bank of Dallas