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Consumer worries belie stable economy

Nell Henderson The Washington Post

Consumers can’t be blamed for feeling grumpy. With prices rising and interest rates creeping up, bargains are harder to come by and it’s too late to land a 30-year fixed-rate mortgage anywhere close to 5 percent.

But should they be nervous? Are we getting close to some tipping point, when costs start to spiral?

As in the 1960s, war costs are helping to swell the budget deficit. As in the 1970s, turmoil in the Middle East is pushing up oil prices. As in the 1980s, interest rates are headed higher.

Remember those days: 13 percent inflation and 30-year mortgages at 18.5 percent. It took nearly 5 percent of a family’s annual income just to fill up the car with gas.

Economists say there’s no need to hyperventilate yet. Interest rates and inflation are still near their lowest levels in decades. Today’s economy is structurally very different, and policymakers have learned from the mistakes made back then.

Still, an arched eyebrow could be forgiven.

“The dynamics of the inflation process are not well understood,” Federal Reserve Bank of Philadelphia President Anthony Santomero said in a speech last week. “The economy rarely, if ever, evolves as smoothly as we forecast. Its dynamics are complex and events we cannot now foresee will undoubtedly come into play.”

One of the biggest sources of unpredictability going forward is the consumer. Consumer spending accounts for two-thirds of the nation’s economic activity, so consumers’ reactions to rising prices and interest rates will have great economic effects.

If they just accept price increases, that could encourage businesses to raise prices further. If they cut way back on spending, economic growth could stall.

Fed officials, who try to stabilize the economy by targeting certain short-term interest rates, are watching consumer spending closely. Even officials with very benign views of the economy’s probable course worry that if consumers and businesses expect more inflation, those expectations will fan price increases. So the Fed is conducting a campaign to assure the public that it is on the case and will not let the inflation genie out of the bottle.

Some Fed critics, however, believe the bottle is already uncorked. They point to recent rises in prices for energy, steel, lumber and other raw materials as developments that will force businesses to raise the prices of cars, appliances, houses and other products — if consumers will accept them. And while overall inflation is very low, these critics worry that consumers already expect more price escalation because many household expenses have spiked. Think gasoline, food, health care, tuition, cable bills and houses in many markets.

On the whole, Fed officials depict the economic outlook for the coming year as generally sunny. Several have said recently that they expect the economy to continue to expand strongly, job creation to build steadily and inflation to remain tame.

While the Fed is getting ready to start raising short-term interest rates to prevent inflation from blasting off, policymakers have said they will be able to do so very gradually because inflation is still so low — around 2 percent. By contrast, when the Fed launched a campaign to throttle inflation in 1979, it was already above 13 percent.

A bit of history may help to understand why the Fed is optimistic that it can navigate these tricky waters and bring the economy into a long, healthy expansion.

One cause for comfort is that the U.S. economy today is far more stable — that is, less prone to bursts of high inflation and swings into deep recessions — than it was in the 1970s and early ‘80s.

Since then, inflation dropped from a high above 13 percent in 1979 to a level so close to zero last year that Fed officials worried about the possibility of deflation — a potentially damaging fall in the overall price level — and are relieved today that it has edged up from such dangerous territory. (Inflation may be bad, but deflation can be worse. Think Great Depression.)

Recessions in the past two decades have been shorter, shallower and less frequent.

The nation lived through four recessions, covering a combined 49 months, between December 1969 and November 1982. The unemployment rate soared as high as 10.8 percent during the recession of 1981-82.

By contrast, the period since then has notched only two recessions that lasted a combined 16 months. During those contractions, the jobless rate went no higher than 7.8 percent.

Between those two downturns, from March 1991 to March 2001, the nation enjoyed continuous economic growth, the longest peacetime expansion on record.

Researchers have offered several explanations for this calming of the economic waters.

First, the economy’s structure has changed in a number of significant ways. Deregulation of airlines, telecommunications, finance and other industries has fostered more competition, which restrains prices. Globalization and the removal of many trade barriers have exposed U.S. companies to more competition from abroad, forcing them to become more efficient and holding down price increases. Businesses cut costs and boosted their efficiency through advances in computers, telecommunications and other new technologies, making it easier to profit without raising prices.

The evolution of more complex national and global financial markets during the past quarter-century has made it easier and cheaper to finance a business or home purchase, while spreading financial risk more widely.

Fed Chairman Alan Greenspan has said frequently that these developments have made the economy more flexible, enabling it to more easily absorb the kinds of shocks — a stock market crash, foreign currency crisis or terrorist attack — that might have caused more economic damage decades ago.

Workers today are also far less likely than they were in the 1970s to get automatic wage increases when inflation rises. Union membership has fallen to 13 percent now from 24 percent in 1979.

Fed officials today are concerned about how consumers will react to rising prices and interest rates.

“Expectations that prices will go up make people more willing to pay more,” said Joseph Sirgy, a consumer psychologist at Virginia Polytechnic and State University.

One key to consumer response will be the pace of change, said George Loewenstein, a professor of economics and psychology at Carnegie Mellon University. “People can get used to almost anything,” he said, provided changes are gradual.

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