The US inflation scare seems to be over. For a few days after 18 September, when the Federal Reserve cut the overnight interest rate by half a percentage point, the central bank’s anti-inflationary credentials seemed to be under threat. But bond yields, which had jumped up by 15 basis points, have since fallen back to pre-cut levels.
There are several reasons for the fast return of faith in the Fed. To start with, the Fed’s firm rejection of accusations of laxness helped investors put a negative spin on the subsequent US economic data—too weak to support much higher prices. Also, prices aren’t rising. The consumer price index was lower in August than in June and oil seems to have peaked. Still, it is too early to declare victory. Indeed, the two biggest threats to US price stability have not been tested.
The first threat—higher import prices —will be gauged fairly soon. Imports account for less than one-sixth of gross domestic product (GDP) and play a larger role in setting inflationary expectations. The bill at Wal-Mart has a big effect on American consumers’ view of prices.
If those bills rise too fast—pushed up by a falling dollar or by increasing inflation in China and other exporting countries—wage demands could become more aggressive. With unemployment still low, it could be relatively easy to get a price-wage spiral started.
The second threat is more serious, but quite distant. That is the possibility that the government will come to the rescue of stretched homebuyers with some sort of inflationary programme. It’s too early to think of details, but tumbling house prices could put politically unsustainable pressure on US household balance sheets. However a house price-support programme is designed, it would be likely to push up the overall rate of inflation—either directly by increasing incomes or indirectly by increasing government borrowing to subsidize otherwise bad loans.
After two decades of falling and low inflation, the Fed has a lot of credibility, but the current problems of the dollar and the housing market may yet test it.