Evans On The Economy -- Beware Of The Sour Spot

It happens almost every business cycle.

Following several years of uninterrupted expansion, the U.S. economy starts to slow down while inflation accelerates. The Federal Reserve raises interest rates and restricts the growth of money and credit. The economy hits a sour spot. And, eventually, there's either a severe slowdown or an outright recession.

The pattern occurred with monotonous regularity in the post-World War II period -- until the late 1990s. The U.S. economy kept gaining speed at the same time that the inflation rate actually declined. As a result, economic recovery lasted for almost an entire decade, until it was ended by the stock market correction and the drop in demand associated with Sept. 11. The ensuing recession, however, was unusually mild -- and by some measures hardly existed at all. That led to speculation that the sour spot, a combination of little or no growth and rising inflation, had been wiped out -- not unlike speculation earlier in the 1990s that the business cycle itself had been eliminated.

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We are at a crossroads. The core rate of inflation has remained around 2%, but that term loses much of its meaning when oil prices rise almost steadily over an extended period of time. With the overall Consumer Price Index now rising at more than a 4% rate, it is fatuous to pretend that inflation is no longer a serious economic problem.

In contrast, the stability of the inflation rate in the late 1990s was due to four unusual, if not unprecedented factors, namely:

The federal budget deficit was declining and would soon turn into a surplus. (Now we're in deep deficit.)
Productivity growth accelerated beginning in 1996. (While it is still slightly higher than average, it has declined substantially from its peak in 2002-2003.)
The dollar strengthened from 1995 through 2000. (In general it has weakened since then.)
Commodity prices didn't show any signs of rising in the late 1990s. (In this economic recovery, they have reverted to form, growing by double-digit rates even excluding energy prices.)

It's true that recent federal budget estimates show the deficit smaller than previously estimated, but it is still more than 2% of GDP at a time when the economy is essentially at full employment. And even liberal economists generally think the budget ought to be balanced at that juncture. Productivity growth has declined to 2% and is almost sure to slow further as the economy heads into stagnation. The value of the dollar will depend in part on what newly installed Treasury Secretary Hank Paulson has to say about it, but the economic factors generally point to further weakness as the economic growth rate declines and the stock market weakens. And even if energy prices do stabilize and then decline, the huge increase in other commodity prices will eventually spread throughout the economy to a much greater extent than has been the case so far.

In addition, the Fed made what will eventually be seen as a serious mistake by holding the federal funds rate at the ridiculously low level of 1% until mid-2004. Chairman Alan Greenspan retired a hero, but 10 years from now I doubt if he will be held in the same high esteem.

Inflation can still be contained, but it will take a greater effort from the current Federal Open Market Committee than we have seen so far. It's a case of pay me now or pay me later. If the Fed does not take unmistakable steps to convince the financial and business markets that they are serious about fighting inflation at every turn, we will have more inflation now and a more serious recession later.

Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla. Also see: Economic Outlook and Financial Market Outlook: Mike Evans' blogs on the economy and stock market.