Fed must beware inflation risks

This US business cycle is something new: never before have interest rates been slashed so far, so early. That aggression was justified because when the Federal Reserve made its last big rate cut in March the US economy seemed on the brink of financial catastrophe. Now, however, inflation risks are creeping upward, and any improvement in financial conditions will mean that policy is too loose.

Back in March, when Bear Stearns went down, the US was at risk of a spiralling financial crisis. Parallels were drawn with 1929 – and they were not ridiculous. The Fed therefore cut rates by far more than the growth and inflation data would normally justify to offset banks' extreme reluctance to lend.

The result is low interest rates – which the Fed held at 2 per cent on Thursday – despite headline inflation running at 4.2 per cent. At first glance that policy looks far too accommodative. But because companies and consumers are having to pay such high premia to compensate banks for the risk of illiquidity and default, effective interest rates in the economy are much higher.

That will change the instant that risk premia start to fall, which they could do rapidly once they start to move. There is, as yet, little evidence of economic disaster: annualised growth for the first quarter of 2008 was revised up to 1 per cent on Thursday because exports and consumer spending were stronger than previously thought. The much-feared recession may never happen.

Price rises, meanwhile, are cause for nervousness. Public surveys of inflationary expectations, although not that reliable, have risen sharply; implied expectations in the bond markets are not so high, but hard to interpret because of a flight to the safety of Treasury bonds. The Fed should not be overconfident about its ability to tame expectations if they get out of control.

There is also an international dimension to inflation: low Fed rates mean that countries with currencies pegged to the dollar have to choose between exchange rate appreciation and high domestic inflation. So far they have accepted the latter – and stoked up global inflation in the process – but another risk is that they reverse course and allow the dollar to fall.

The Fed is right not to commit to rate rises in advance but its statement on Thursday could have been even tougher. Unless the economy deteriorates, it should plan to raise rates later this year, and if risk premia fall it should quickly raise rates to compensate. If inflationary expectations begin to get out of hand, however, the Fed should forget about growth and squash them.

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