What Would Greenspan Do? Bernanke Weighs Risks of Rate Increases and Rising Inflation

By GREG IP WSJ May 22, 2006; Page A2 REMAINDER: click here ...

After a string of interest-rate increases, the U.S. economy is starting to soften, but inflation is edging higher. That poses a dilemma for new Federal Reserve Chairman Ben Bernanke: Should the Fed worry more about rising inflation and raise rates further, risking a recession? Or should it worry more about growth and hold rates steady, risking higher inflation and a loss of credibility? The outlook for global stock and bond markets will hinge on the outcome of that decision.

It is a situation similar to what his predecessor, Alan Greenspan, faced three times in his 18 years as chairman, in 1989-90, 1994-95 and 1999-2000. In each case, he stopped raising rates before inflation peaked. Two episodes resulted in recession, one in a growth slowdown; in each, inflation ultimately ended lower than it began.

"This is a problem central banks have wrestled with for many, many years," said Mark Gertler, a monetary economist at New York University. A 1995 study of historical experience he wrote with Mr. Bernanke, then a Princeton University academic, found that economic growth begins to slow roughly six months after the Fed tightens monetary policy. But inflation doesn't begin to ease until about year has passed.

The result often is an uncomfortable period when growth is slowing, inflation rising and the central bank facing a tough choice between higher rates and watchful waiting.

That may be where the U.S. economy is now. After a first-quarter surge, growth is slowing, as higher interest rates and energy prices take their toll on housing and consumer spending. It "seems pretty clear that the housing market is cooling," Mr. Bernanke said Thursday, though the slowdown is quite "orderly and moderate." But core inflation, which excludes food and energy, reached a one-year high of 2.3% in April...