The Fed faces concerns of a ’70s-type economy

Most prominent economists don’t expect a return to double-digit inflation.

McClatchy Newspapers

WASHINGTON — Not since the 1970s has the U.S. economy faced such an ugly combination of a persistent energy shock, a looming recession threat and menacing inflation that stays stubbornly high — even in the face of a screeching slowdown in growth.

This combination has the Federal Reserve, charged by law with both sustaining growth and curbing inflation, in a bind. It must balance the needs of protecting the economy from a downturn while protecting it against an upward spiral of prices — and doing either one can make the other far more difficult.

In addition, this dilemma comes amid the worst housing slump in modern times, as well as an unprecedented crisis in credit markets whose positive outcome is far from certain. Adding to the troubles are the dive of the U.S. dollar against other currencies and rising global inflation that partly mutes whatever action the Fed takes.

“This thing has the potential to really unwind to create huge negative effects,” said Lyle Gramley, a former Fed governor from 1980-85, one of the U.S. economy’s most turbulent periods. “The Fed is walking a tightrope right now, that’s for sure.”

Laurence Meyer, a Fed governor from 1996 to 2002, sees some parallels between today and the late 1970s and early 1980s, when the oil-dependent U.S. economy saw double-digit inflation largely because of an unexpected energy shock. Growth fell while inflation rose, creating stagflation — a stagnant economy and high inflation.

Today’s problems, he said, reflect “the first really persistent [oil] shock we’ve had since the 1970s, and the inflation expectations are worse than we have had over the past decade. So we’re kind of in a middle area.”

Neither Meyer nor most other prominent economists expect a return to double-digit inflation. Policymakers learned from the Fed chairman back then, Paul Volcker. He pushed interest rates up so high that they crushed double-digit inflation. But it came at a huge price — the job-killing 1981-82 recession, worst since the Great Depression. To kill inflation he first had to squash growth.

But once the inflation dragon was slain, the ’80s economy boomed, and Ronald Reagan won a landslide re-election in 1984 on the slogan that it was “morning in America.”

Today there’s no chance that Fed Chairman Ben Bernanke will ignore inflation; the question is how long will its rise be tolerated before he acts to tame it.

Pressure is growing on him to act soon.

“We need to take steps to ensure that inflation does not get out of control. We need to act pre-emptively,” Charles Plosser, president of the Federal Reserve Bank of Philadelphia, told CNBC television on Thursday.

In a June 9 speech, Bernanke said he’d “strongly resist an erosion of longer-term inflation expectations, as an un-anchoring of those expectations would be destabilizing for growth as well as for inflation.” That means that he’ll raise rates quickly if consumers and businesses show signs that they’re beginning to expect inflation will keep rising.

“That’s recognizing the important thing that went wrong in the ’70s. But he’s not saying it has happened yet,” said Meyer, who expects rate increases only after it is clear that the U.S. economy is on more stable footing and that recession threats have eased.