Through the Inflation Looking Glass - TheStreet


suspension of disbelief regarding inflation continues. While many economists expect economic growth to rebound sharply in the second half of 2001 and into 2002, few foresee an accompanying threat of higher inflation.

Yet, a growing number of economists are starting to concede that the


may need to begin raising rates by year-end, barring a resumption of the so-called productivity miracle. Without a return to strong productivity gains, it gets harder for market watchers to see how a return to growth doesn't spark inflation and, with it, a tighter Fed policy.

There's little question that the conventional wisdom among economists anticipates a return to growth in the next several months. For example, economists predicted U.S.

gross domestic product

growth of 2.3% in the second half of 2001 and 2.8% in 2002, according to the

Philadelphia Fed's


"survey of professional forecasters."

At the same time, the forecasters expect inflation, as measured by the GDP price index, will rise 2.3% for all of 2001 and just 2.1% next year. As measured by the year-over-year change in the

consumer price index

, inflation is expected to rise 3% in 2001 and 2.5% in 2002. (The May CPI, due on Friday, is expected to rise 0.4%, and core CPI is expected to rise 0.3%; each would be a 0.1% rise from April.)

True, economic growth does not necessarily lead to inflation, just as inflation does not need robust growth to thrive, as the 1970s demonstrated.

But if the growth-without-inflation forecasts of most Wall Street economists come to pass, a revival of the productivity miracle is critical, if not required. First-quarter productivity declined 1.2%, but many economists believe technology-led productivity will keep inflation at bay, including Stephen Slifer, chief U.S. economist at

Lehman Brothers


"We've been in the 'New Paradigm' camp, and I fully believe what we saw in the first quarter was probably the low point in quarterly productivity," Slifer said. He predicted productivity will grow 2.5% in the second quarter and re-approach 3% by year-end in conjunction with his forecast for GDP growth to rebound to 3% in the third quarter, 4% in the fourth and 3.7% in 2002.

"I'm having a tough time seeing where inflation comes from because of a resumption of gains in productivity, and given what's happening with commodity prices and the dollar," the economist added, noting the dollar's continued strength and falling commodity prices.

Back to Slifer in a minute. First, back to that Fed survey. Along with solid growth predictions, the forecasters expect "a substantial upward revision" in the spread between long- and short-term interest rates (a.k.a., a steepening of the

yield curve). But -- again -- the survey respondents see little threat of inflation, even in the long term, anticipating CPI inflation will average 2.5% over the next decade. Notably, that forecast is unchanged since the second quarter of 1998. During the intervening months, CPI inflation has edged stubbornly higher, suggesting respondents may be making the classic error of forecasting by simply extrapolating the current trend out in time.

The survey results indicate the forecasters' belief "the yield curve is steepening not because financial markets expect higher inflation but

for other reasons," such as the

Treasury Department's

ongoing buyback program, said Tom Stark, an economic analyst at the Philly Fed.

Stark was analyzing the results of the survey, not presenting his own opinions or those of the Philly Fed (he declined to give either).

But he did offer an unsolicited opinion on the quality of such forecasts, noting "individuals may not have an incentive to report the most accurate

forecast, but rather one he thinks won't get him in trouble if he's wrong."

In other words: If the so-called productivity miracle is

good enough for Federal Reserve Chairman

Alan Greenspan

to continue to promote, it's good (and safe) enough for Wall Street economists.

Stark's stark (

couldn't resist

) comment led to the broader question of just how accurate the survey's forecasters have been. Other than "about as accurate as other popular surveys," the analyst conceded it's a difficult question to answer because "accurate" is a loosely defined term. For that reason, accuracy has become the subject of academic debate and research, he said.

"Economists were perhaps premature in thinking the survey forecasts were worthless" after the 1970s because their prognosticating prowess improved in the 1980s, the Philly Fed's

1998 study of the subject concluded. "But at the same time, the forecasts don't inspire a tremendous amount of confidence, either."

For example, the forecasters predicted GDP growth of 5.2% in 2001 in the survey conducted for the fourth quarter of 2000. That's more than a miracle away now.

Why This Matters

Wall Street's relaxed attitude about inflation was reflected today in the bond market's sharp rally, which saw the price of the benchmark 10-year note rise 14/32 to 97 25/32, its yield falling to 5.29%. With key economic data not due until later in the week, fixed-income traders focused on Japan's weak GDP report and the setback in equities. The

Dow Jones Industrial Average

fell 0.5%, the

S&P 500

lost 0.8% and the

Nasdaq Composite

shed 2%.

Of course, the bond market is also recouping prior losses. The 10-year note's yield is still about 50 basis points higher than before the Fed's third ease on March 21. As

previously reported, that's when stocks really started benefiting from the rate cuts.

Also inspiring bonds today were comments from

Dallas Fed


Robert McTeer

, who said the economy is "probably at or near the bottom" of the slowdown but that "the inflationary picture is reasonably good," according to wire service reports.

McTeer also said "monetary policy has put the pedal to the metal," suggesting it's only a matter of time before this year's easings reinvigorate the economy.

McTeer's comments echoed those of Fed governor

Laurence Meyer

, who on May 24

said "...attention must also be given to calibrating the easing to avoid overshooting in the other direction in a way that ends up adding to price pressures as growth strengthens."

To Diane Swonk, deputy chief economist at

Bank One

in Chicago, Fed officials are conveying a message that inflation is currently contained in order to provide cover in the ongoing war of easing vs. the threat of recession.

But "the economy may already be bottoming and has a lot of stimulus coming down the pike" from both the monetary and fiscal fronts, she said. Fed officials are thus "laying out a rationale for what they will do: Just-in-time Fed policy can go in both directions."

In plain English, Swonk believes the Fed will start tightening again later this year because of inflationary pressures. She foresees the

fed funds rate back to 5.5% by year-end 2002.

Recalling Swonk has long warned against

inflation's return, some readers might thus dismiss her as hawkish (for lack of a better term).

But even inflation doves (for lack of a better term), such as Lehman's Slifer, foresee the Fed back in a tightening mode before long. Slifer forecasts another 25 basis points at the

Federal Open Market Committee's

next meeting, but the Fed then gradually taking the fed funds back to 5% by the end of 2002.

"If we get growth back to potential and fed funds are stimulative, I don't want to suggest the Fed can go willy-nilly" and ignore the potential for inflation's return, he said.

That, dear readers, is the issue for investors with time horizons closer to six months than six minutes.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.