Global Policy Forum

By Joel Havemann

Some economists say political risk and global commodity demand are pushing up prices. In that case, Fed rate hikes will have limited effect.

When Federal Reserve Chairman Ben S. Bernanke testifies about the economy to a Senate committee this morning, all eyes and ears will be on his view of inflation and any hints about whether he will keep raising interest rates to curb it. But some analysts think the Fed wields less influence over inflation these days, making higher interest rates less effective as a tool to control it. They fear that further hikes could end up slowing the economy and hurting consumers without constraining prices.

Today's inflation, these economists believe, is driven substantially by the value of commodities and basic materials -- oil as well as copper, aluminum, steel and others. That commodity inflation, they argue, is the result of forces largely beyond the scope of high U.S. interest rates: volatile politics in the Middle East, for example, and rising demand for materials from the rapidly growing economies of China and India. "Most of our inflation is in commodities, and it is driven by global tensions and growth in foreign countries," said David Kelly, chief economist for Putnam Investments in Boston. "It's outside the reach of U.S. monetary policy."

Tuesday's news that China's economy surged an unexpectedly robust 11.3% in the second quarter underscores the dilemma. The Fed can do little to control China's growth. It is up to the Chinese, not the Fed, to raise their interest rates to rein in their overheated economy, experts say.

The Fed and Bernanke will get fresh data on inflation this morning, when the Labor Department releases the consumer price index for June. In a preview of that data, the department reported Tuesday that producer prices -- targeting the wholesale level -- rose an unexpectedly strong 0.5% in June. That was propelled by a 1.4% jump in food prices, which in turn were boosted by a 15% increase in costs for fruit. Excluding the volatile food and energy sectors, so-called core producer prices rose only 0.2%, in line with economists' expectations.

Economists are watching the behavior of the core indexes for signs that the run-up in oil and natural gas prices will spill into the costs of goods and services produced with large amounts of fuel. So far there have been few such indications. But Ian Shepherdson, chief U.S. economist for High Frequency Economics, a consulting firm in Valhalla, N.Y., warns against overconfidence.

Referring to the vast range of economic activity that includes banks and healthcare, education and retailing, he said, "The real inflation risk is in services" because the service sector has yet to pass along most of the commodity price increases it is seeing to its customers. But food and energy absorb a large and growing share of most U.S. household budgets. To the extent that their prices are set overseas, there is relatively little the Fed can do to reverse the trend, some economists say.

There is no doubt that commodities are contributing significantly to consumer inflation. The commodities component of the consumer price index rose 4.3% in the 12 months ended in May and at an annual rate of nearly 10% in the three months ended in May. "I don't think we should be using monetary policy to combat this," economist Kelly said. He argued that driving up interest rates in response to commodity price increases has a perverse effect: It slows the economy and leaves workers with less in their pockets to pay for gasoline and other products that depend on raw materials, the prices of which are largely sheltered from Fed policy. "The problem is not well-addressed through monetary policy," seconded Dean Baker, co-director of the Center for Economic and Policy Research in Washington. Tight money pressures wages, he noted, again making commodities that much harder to afford.

Stephen Roach, chief economist for Morgan Stanley, said it was not only commodities but manufactured products whose costs eluded U.S. control. It has taken too long, he said, for government economists to realize that "in a globalized economy, manufacturing prices are set globally, not locally."

As the economy becomes more global, national authorities everywhere are finding it more difficult to regulate economic conditions at home. U.S. officials have found such major new economic players as China to be unpredictable, if not unreliable. The Chinese have been reluctant to let their currency gain value, a step that would reduce their massive trade surplus with the United States. And they have raised interest rates only once this year, not enough to prevent double-digit economic growth in the April-June period.

A cooling of China's red-hot economy would take some of the pressure off worldwide prices of commodities and manufactured goods. But to the senators who will question him today, Bernanke will probably appear to have his hands full with what's going on in the United States.

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