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The Inflation Answer

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Inflation or no inflation? That's the big question now.

Fed chairman Ben Bernanke suggested yesterday that there will be no more easy cuts in interest rates. Is he succumbing to the growing pressure from Wall Street and hard line mainstreamers that inflation is now America's concern, not recession?

Until now, he's admirably resisted that. On Monday, happily, Paul Krugman also registered his doubts in the New York Times about the case the inflation hawks are making. There is no wage-price spiral anything like there was in the 1970s. Yes, oil and food prices are soaring, like they did back then. But the foundation of future rising inflation is when they become embedded in the economy. As I've written here before, we are far from that. Any sign of weakness in the economy, and those oil and food prices may come tumbling down because speculation is driving them part of the way up.

But it may once again be bond traders who have the last word. They are driving up interest rates because they habitually over-react to inflation fears. Should Bernanke now mollify them with a harder line?

Go with the facts, not the psychology, is my answer. The concern among those who are sincere in their fear of inflation is that any sign of giving in on inflation by the Fed will lead us down a slippery slope. Inflation will slowly rise, so will inflationary expectations, and the spiral will begin again. Interest rates will go up and slow the real growth of the economy.

But the Fed would make a mistake to give into these fears. First of all, any reasonable monetary economist in the mainstream will tell you that there is no evidence that somewhat higher levels of inflation will undermine real growth. (There are unreasonable and usually less well-informed ones, of course, who will vehemently deny this.) Serious cross-country research shows no negative real effect on growth until inflation reaches ten or twelve percent a year. So rates at 3 or 4 percent are not to be mortally feared. For central bankers, that means a little more flexibility is just fine. We don't have to stop the economy cold every time inflation jiggles up.

But inflationary expectations are not close to spiral levels right now, anyway. People's expectations--despite all the Chicago school theory that states they are based on a clear reading of the future-- are rooted in the past, and inflation has been low for a long time. It will take a lot to unleash them.

Second, the Fed is very different now and won't let inflation rise too long too fast. Theory and attitudes have changed too much. The policy consensus is overwhelming.

Third, as stated, oil and food prices probably won't hold at these levels if the economy weakens.

There are also so-called experts who are not sincere, keep in mind. Low inflation serves the interest of many well-heeled investors, and such experts win points, and probably a raise, when they make the hard-line case. They will keep pressuring the Fed.

So, Mr. Bernanke, don't tell the markets you won't cut rates. Maybe you won't, but wait to see how the economy is doing. As I write this, reported auto sales are terrible. Recession would be a lot more painful than a bit of temporary inflation. And let the bond traders do their thing. They will find they were wrong, and lose some money in the process. That's the only way they'll learn.