WSJ: Don’t Forget about Inflation

From a Saturday OpinionJournal.com editorial that channels Don Luskin:

If there’s a real red flag in yesterday’s economic data, it’s the inflation numbers. The personal-consumption expenditures deflator–the inflation measure used to derive real economic growth from the nominal figure–rose at a 3.4% rate in the first quarter. The “core” number, which excludes food and energy prices, rose by 2.2%, still above the Federal Reserve’s comfort range. The core number has now been above 2% for more than a year, and the inflation expectation for the coming year, as measured by the Bureau of Labor Statistics, is above 3%.

There’s still too much underlying strength in the economy to call this stagflation; it looks more like “growthflation,” to borrow a phrase from economist Michael Darda. The Fed has been betting that slower growth would bring inflation down, thus vindicating its decision to stop raising interest rates last year. But we all learned in the 1970s, or should have, that inflation can coexist with slower growth.

Inflation is a monetary phenomenon, and bringing it under control means creating fewer dollars. We doubt the Fed will find much inflation comfort in Friday’s data, and it shouldn’t. With gold near $700 an ounce and the dollar hitting record lows against the euro, the danger is too much dollar liquidity, not too little. The Fed has been hoping to see how bad the housing slump gets before it considers further tightening, but in the meantime price pressures have been building and dollars are sloshing around the world. As we said last year, we think the Fed would have done better had it not gone on “pause.”

The stock market closed basically flat on Friday, suggesting that the headline GDP weakness didn’t spook anyone much. The Dow’s march into record territory this week signals that investors believe that the economy will emerge from this inflationary period intact. But Wall Street’s professional economists have been underestimating the inflationary threat since this cycle began. There’s no sign that this has changed, which means that the further tightening that the Fed will likely have to come to grips with may come as a rude awakening to some Wall Street pros.

All of which is another reason that this is exactly the wrong moment for Congress to be toying with tax increases and protectionism. The 2010 expiration of the 2001 and 2003 tax cuts is looming ever-larger as an economic question mark. We can expect to feel the effects of that event long before New Year’s Day, 2011. Tax rates affect decisions throughout the economy, and unless those cuts are made permanent, or a pro-growth tax reform is put in place to replace them, their expiration will influence economic activity before that day arrives. Economic decision-makers, like the markets, try to look forward, rather than back.

I think we might see the negative impact of the looming tax cut expiration (i.e., the huge, looming tax increase) as early as the middle of next year — just in time for presidential campaign crunch time, and just in time for tax-hungry politicians to blame it everything but the real cause.