Risks Close In on the Fed

WASHINGTON — Ben S. Bernanke’s honeymoon as the new Federal Reserve chairman is drawing to an end.

Now comes the hard part.

The Fed has reached a crunch point in its stewardship of the U.S. economy, and any misstep on Bernanke’s part could have dramatic consequences.

Inflation is picking up just as economic growth and job creation appear to be slowing. The housing boom is ending, and rising mortgage rates threaten to depress home prices and throttle consumer spending. Gasoline prices are rising and the dollar is falling, portending increases in what Americans pay for foreign goods: energy and electronics, coffee and clothing.

What’s a new Fed chief to do?

If Bernanke’s Fed continues to raise interest rates, it risks choking economic activity, particularly the rate-sensitive housing sector, a prime engine of growth since the 2001 recession. But if it doesn’t, Bernanke could get a rap as being soft on inflation -- and prices could rise even more.

It’s a predicament that would challenge the legendary Alan Greenspan, whom Bernanke replaced Feb. 1.

“Even the great Greenspan would have trouble figuring out the best policy,” said Nariman Behravesh, chief economist for consulting firm Global Insight. “The Fed doesn’t know -- nobody knows -- what the economy is going to do next.”

Experts even disagree on what the economy has already done.

“Consumers are becoming much more cautious,” Brian Bethune, Global Insight’s U.S. economist, said after looking at last week’s economic news. By contrast, Moody’s Investors Service told its clients that “consumers are not holding back.”

Molding policy to shape the future is still more problematic. Economic policy changes such as interest-rate hikes have their maximum effect months or even years after their implementation. By then, the problems they addressed may have evaporated. And the Fed’s best efforts to fine-tune the financial climate in the United States can be swamped by changes in the global economy.

Compared with Greenspan’s first crisis, the economic landscape that Bernanke faces seems downright orderly. Less than three months into his term, Greenspan was hit with the stock market crash of Oct. 19, 1987, when the Dow Jones industrial average lost 508 points. Greenspan responded by pumping money into the economy, a step widely seen as crucial in preventing a recession or worse.

Bernanke’s choice may make the difference between growth and stagnation, between price stability and inflation. Several years into the economic expansion, growth is inevitably coming down from its immediate post-recession highs. Policymakers want to prevent the slowdown from turning into another recession and do it in a noninflationary way.

That outcome -- called a soft landing -- requires a delicate balancing act. Thanks in part to a burst of productivity growth that accompanied widespread adoption of improvements in computer technology, Greenspan’s Fed pulled it off in the mid-1990s. The economic expansion of that decade was the longest ever.

But right now, both growth and inflation seem to be moving in the wrong directions.

In the first three months of 2006, the economy swelled at an annual rate of 5.3%, the government reported Thursday. But that burst merely offset the hurricane-depressed 1.7% registered in the last three months of 2005, and most economists foresee a slowdown to less than 3% by the end of this year.

Consumer spending, a major force behind the current expansion, is strong but shaky, weighed down partly by high gasoline prices. Consumer confidence, as measured by a University of Michigan survey, tumbled this month to its lowest level since October, when the nation was grappling with Katrina’s devastation.

The Commerce Department reported Friday that consumer spending rose 0.6% in April. But income rose only 0.5%, and, for the 11th straight month, consumers spent more than they earned.

Credit cards accounted for some of the debt. But over the last couple of years, low mortgage interest rates have enabled more homeowners to refinance and borrow against the value of their homes without increasing their mortgage payments. Now the combination of decelerating home values and rising interest rates has ominous implications for consumer spending.

Prices, meanwhile, are hardly behaving any better.

The price index attached to personal consumption expenditures -- a measure that takes into account consumers’ shifting buying habits in response to price and quality changes -- rose 0.5% in April, the Commerce Department reported Friday. Gasoline was a major factor, but even when the volatile prices of energy and food are excluded, this index has risen 2.1% in the last year -- a notch above the top of Bernanke’s “comfort range.”

Bernanke’s primary mission is to steer the economy to a sustainable growth path with subdued inflation. Should the agency’s policymaking Federal Open Market Committee, which next meets June 28 and 29, continue its 2-year-old campaign of ratcheting up short-term rates in the name of fighting inflation? Or should it pause its quarter-percentage-point hikes and give the economy some breathing room?

Bernanke has said the decision should depend on the latest economic data. But focusing on data alone leaves the Fed looking backward. Thursday’s report of strong economic growth, for example, covered the first three months of 2006, a period that began nearly five months ago.

The Fed also needs to look forward. But that task is difficult partly because of the lag between interest rate changes and their economic effects.

In a paper that he co-authored in 1995 as a Princeton University economist, Bernanke found that rate increases began to weigh on economic growth within four months. But the desired effect -- pressure on prices -- showed up after about a year. That leaves an uncomfortable period of eight months when the Fed is responsible for pain but no gain.

The Fed also is limited by its policy tools. It directly determines short-term rates, but longer-term rates are primarily set by the markets.

That disparity has been particularly noticeable in recent years. In June 2004, when the Fed began raising its benchmark short-term rate from its floor of 1%, 10-year Treasury notes yielded about 4.7%. On Friday, even though the Fed’s short-term rate had risen 4 percentage points to 5%, the 10-year Treasury yield was only 5.05%.

Even if all interest rates moved exactly in step with the Fed’s wishes, they would not necessarily have the desired effect. David Kelly, economic advisor to Putnam Investments in Boston, said business investment had swung from structures to software and equipment during the last half-century. Investment in software and equipment entails less borrowing, so it is less sensitive to interest rates.

What’s more, today’s high corporate profits have enabled businesses to expand without borrowing -- again, insulating economic activity from interest rates.

Further confounding the Fed is the extraordinary mobility of capital and labor in the increasingly globalized economy. The volume of U.S.-owned assets abroad and foreign-owned assets in the U.S. has soared about tenfold in the last two decades. The flow has been unequal, however, thanks to the U.S. trade deficit. Foreigners held $12.5 trillion worth of U.S. assets in 2004, compared with the $10 trillion in foreign assets held by Americans.

On the whole, globalization has probably made it easier for the Fed to rein in inflation by making relatively inexpensive imports widely available, Fed board member Donald L. Kohn said in an October speech. But the Fed has little influence over economic activity and policy decisions made overseas.

“Globalization has made my job more interesting but no easier,” Kohn said.