Fed Chief Looks for Moment to Apply the Brakes

Batten down the hatches. America is about to be overwhelmed by an inflationary wave that will threaten the value of the dollar and its ability to remain the world's reserve currency. Or not.

Much of the news of late has been a lot cheerier than the reports that descended on us only a few months ago. The interbank lending rate is below 1%, well down from the 6% peak it reached when banks were so unsure of the ability of their counterparties to survive that they refused to lend, even overnight. The housing market is showing signs of life, with inventories of unsold houses beginning to get sopped up in some of the hardest-hit cities. Consumers are spending more freely. Retail sales in April recorded their largest gain since August of last year, with Wal-Mart leading the way. Inventories of goods have dropped to levels that will soon require shopkeepers and others to restock their shelves. Consumer panic is giving way to a more confident outlook. Even the job market is showing tiny signs that the worst is over.

Which is not entirely good news for Ben Bernanke and his colleagues on the board of the Federal Reserve Bank. Until now, they had an unambiguous goal: to do everything necessary to avoid a collapse of the financial system, and pump cash into the economy to prime the pump, as we were wont to say in the 1930s. Bernanke did what he had to do and, most observers agree, did it very well. Not only did he drive short-term interest rates close to zero, putting downward pressure on other interest rates, most notably mortgage rates, but he also seemed to devise one gambit after another to prop up the economy, short of — but not very short of — dropping dollars from a helicopter and demonstrating that his sobriquet, Helicopter Ben, was well earned.

Now, just as the economy might be picking up, all that cash has driven the inflation rate — measured by the most reliable indicator, the GDP deflator — to almost 3%. "Enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation . . . are harbingers of inflation," according to Allan Meltzer, an economics professor at Carnegie Mellon University and author of the authoritative A History of the Federal Reserve.

And not just your garden-variety inflation, observers fear. Andy Xie, former chief economist at Morgan Stanley, Asia, writing in the Financial Times, fears that China and other countries that have been willing to accept the dollar in payment for exports, and hold it, will flee the greenback, producing a "collapse" of the dollar. China's recent purchases of gold are an early-warning sign.

Bernanke now has to decide whether the green shoots foretell a sustained recovery, and whether his policies and the president's trillion-dollar deficits therefore threaten to trigger inflation.

If the answers are "yes", he then has to begin withdrawing cash from the system by selling back some of the assets he has recently added to the Fed's balance sheet. That will displease his political masters, who do not want anything to interfere with a recovery on the eve of next year's congressional elections.

I know — the Fed is independent of the politicians. After all, in the 1980s the fabled Paul Volcker, trotted out by Barack Obama for photo opportunities early in the first 100 days but now sidelined, did wring double-digit inflation out of the system by allowing interest rates to top 20% even though the unemployment rate jumped to a previously unthinkable level of 8%.

But Volcker had the support of President Ronald Reagan. Bernanke might not be so lucky. For one thing, by co-operating closely with the Treasury and the White House, he has forfeited some of the Fed's independence. For another, he is in an awkward position. Although his term as a board member runs until January 31, 2020, his term as chairman expires at the end of January 2010. Should he cool the economy too much, too soon, and threaten to cost the Democrats seats in the congressional elections later that year, Obama has his chief economic adviser, Larry Summers, ready, more than willing, and able to step into the chairman's shoes.

If Bernanke does put on the brakes, and let interest rates rise by refusing to buy all the IOUs the Treasury will be selling to fund Obama's trillion-dollar deficits, he will be placing only one of two drags on the economy. The other is the tax increases the president has announced, many of which will hit in 2011. Such a one-two punch — an interest-rate rise and a tax hike — is generally blamed for aborting the recovery from the Great Depression in 1935-36. If history repeats itself, don't count on the president to leap forward to share the blame for any loss of momentum. Easier to blame the Fed, and nominate Summers to replace Bernanke.

Even if Bernanke is not burdened by the all-too-human desire to hold onto one of the world's most exciting jobs, he must find life more than a little fraught these days. If the recovery proves more robust than the chairman is now predicting, and he waits too long to tighten, double-digit inflation and a dollar stripped of its role as a reserve currency will be his legacy. Act too soon, and risk strangling the recovery in its crib.

Of course, it is possible that fears of inflation are misplaced. Rosy Scenario might return for one more romp around the economy. The economy has substantial excess capacity: factories are underutilised and there are plenty of workers to be hired as the economy recovers. This could prevent prices and wages from rising as the economy grows.

When inflationary pressures do emerge, Bernanke will act. He claims that the Fed is "focused like a laser beam" and has spent its recent two-day meeting on developing an exit strategy to avoid inflation. "We have a plan in place [are] are trying to strengthen and improve it." Now all he has to figure out is when to activate it. Anyone who has tried to call the turning point in a recession can only hope he does a better job than many of his predecessors.