*Task Extra* Yes, Virginia, There Is an Inflation Risk

SAN FRANCISCO -- Having long endeavored to dampen speculation, Alan Greenspan encouraged its return today, and return it has. Stocks soared in the wake of the Federal Reserve's truly surprising intermeeting rate cut today. With less than an hour of trading to go, the Dow Jones Industrial Average was up 3.9%, the S&P 500 was higher by 4.1% and the Nasdaq Composite up 9.3%.

Attempting to put emotions aside (although I'm certainly happy to have been positively disposed heading into today), the key questions are: Why did the Fed cut rates and was it the "right" decision? In conjunction, we'll examine whether the Fed has increased the risk of inflation's return.

The official response to the "why" question, according to the Fed's statement, was that the central bank cut rates today because:

"...capital investment has continued to soften and the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward. This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, threatens to keep the pace of economic activity unacceptably weak."

In plain(er) language, the Fed cut rates today because it was worried recent announcements by companies such as Cisco (CSCO) and Texas Instruments (TXN), which amounted to "things are bad, and there's no sign they're getting better." The Fed eased because it feared a continued decline in business activity -- particularly in the high-tech sector, would lead to more layoffs, which would lead to further decline in consumer sentiment and spending, which would lead to more shrinking of corporate profits, leading to more layoffs, and so on and so on.

"They sat down and said, 'we may be bottoming but things are still soft, profits are weak, tech remains flat on its back' and they did what they could to stem that," said Donald Fine, chief market analyst at J.P. Morgan Chase. "I don't think they're so much worried about recession, but want to make sure [the slowdown] doesn't develop into one. Even 1% positive [GDP] growth means rising unemployment. They're doing what they can to make sure the economy reaccelerates."

Fine believes the Fed is doing a "terrific job" and did the "right thing" today. While many investors would no doubt quibble about the Fed's recent track record being "terrific," most seem to agree with today's decision (surprise, surprise). Further evoking the majority view, the veteran market watcher said that "since inflation for the time being is relatively benign, it stands to reason [the Fed] would focus on unemployment."

But a minority of observers believe inflation is a potential problem, and that the Fed's actions today only make it more so. (This column has long expressed such views.)

"We have seen very rapid growth in monetary aggregates in the first three months of the year -- today's rate cut is not expected to have a retarding effect on monetary growth going forward," said Paul Kasriel, chief economist at Northern Trust in Chicago, who has long warned about inflation's potential return.

M2 money supply growth, adjusted for the Consumer Price Index, was rising at an annualized rate of 8.95% for the three months ended in March, Kasriel reported. That's the highest growth since 10.2% in November 1998 and vs. the recent low of 0.3% in July 2000.

The economist conceded that yesterday's CPI was tame, but noted that for the last three months, CPI is growing at an annualized rate of 4% and 3.5% in the core CPI, which excludes food and energy. "We do have a rising consumer inflation environment, despite what the consensus seems to think."

I know that's an unpopular view and deflation is the hot button on Wall Street. But think about it: Other than share prices, what are you paying less for today vs. a year ago?

On a full year-over-year basis, CPI was growing at 2.9%. in March, which is down from the prior month's 3.5%. The decline in March was largely due to a fall in energy prices, but gasoline prices, particularly, have been on a steep rise since, while the political situation in the Middle East is deteriorating once more. "Headline CPI [for April] is not going to be warm and fuzzy," Karsiel said.

Even at 2.9%, CPI is growing at a far faster rate then in the fall of 1998, when the Fed eased to alleviate concerns about emerging markets and Long Term Capital Management's resulting implosion. At the time, CPI was rising less than 2% on an annualized basis.

Recalling a point made here previously by Jim Bianco, of Bianco Research in Barrington, Ill. (who I could not reach today): The inflation danger arises because the Fed is providing the same medicine for the economy's ills today as it did back in 1998 (actually, a stronger dose), but the starting point for inflation today is much higher.

"The other problem is the rate cuts of 1998 helped fuel speculative excess," recalled John Lonski, chief economist at Moody's Investors Service. "You have to wonder what type of bubble this latest series [of rate cuts] might eventually create. It might not go into the equity market, but maybe household expenditures, which would be an unfavorable turn of events for prices."

Middle Ground

Lonski sort of represents the middle ground on whether the Fed did the "right" thing today.

On the one hand, the economist is concerned about inflationary threats, arguing the Fed is effectively "validating these prices hikes for energy, and by doing so runs the risk of triggering more widespread" price increases. "There's a very good chance when we talk about Fed policy six months from now, we'll be talking about the possibility of Fed rate hikes."

By pumping up money supply to enable consumers to afford higher energy prices, the risk is that the excess money will create higher demand relative to the supply of goods, a classic definition of inflation, he explained. He compared current policies with those of the 1970s, which "ultimately had disastrous consequences."

Finally, "the Fed's latest action tells us it believes it has the ability to engage in fine tuning" of the economy, he surmised.

On the other hand, Lonski gave the Fed credit for its "superb results" in fine-tuning the economy for much of the past decade. Fed critics will no doubt say the central bank overshot in both its tightening and easing efforts, but the broader economic trend has been pretty impressive since the recession of the early 1990s.

But Lonski is skeptical that the Fed can continue to successfully tweak the economy. He noted monetary growth in recent years is unmatched since the late 1960s, which "by the way coincided with the end of a long-lived bull market." Additionally, he wondered how the dollar's strength in the wake of the Fed rate cuts is going to help the beleaguered manufacturing sector, which has witnessed the majority of those layoffs the Fed is purportedly trying to stem.

So perhaps the ultimate question is whether the majority of investors have faith that Greenspan & Co. can again play the economy like a harpsichord. That brings us back to the moral hazard question, to be reviewed in a forthcoming column.

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