ALAN GREENSPAN famously described the failure of long-term interest rates to rise in tandem with the increases he is engineering in short-term rates as a conundrum, a puzzle. The Federal Reserve Board chairman might with even greater accuracy describe the situation in which he now finds himself as a quandary, a state of extreme perplexity.

Start with the contradictory nature of the information about the state of the economy. Last week the government reported that the producer price index had jumped 1% in July, and that even after volatile oil and food prices have been stripped out, the core index rose by a surprising 0.4%.

Surely that is an indication that inflation is taking off, that high oil prices are finally seeping into the prices of other goods, and that interest rates should be raised.

Well, not so surely. It turns out that the core index was driven upwards by seasonal factors and a rise in car prices. Given the wild discounting that is going on in showrooms around the country, that reported rise might be a blip in the data, and is not a reliable harbinger of things to come in the highly competitive car market.

The Fed chairman’s crystal ball is made even cloudier by uncertainty as to just how fast the economy is growing. Initial reports suggested that the economy grew at an annual rate of 3.4% in the second quarter, and many observers, this writer included, expected that figure to be revised upwards when the final tally is made.

But it turns out that subsequent reports of an unexpectedly large spurt in imports mean that consumers bought so many cars, T-shirts and TVs from abroad that growth in domestic output might have been lower than the original data suggest.

Greenspan also has to wrestle with major uncertainties concerning the state of the housing market — hot in some areas, cooling in others — and the rate at which productivity is increasing. With the labour market tightening, and wages inching up, offsetting increases in productivity are needed to keep labour costs under control. So inflation fighters view with alarm the recent decline in the increase in productivity. Output per hour in the non-farm sector — the most widely watched measure of productivity — rose at only 2.3% in the past year, a big drop from 5% in 2003.

That worry might be misplaced. Productivity in the non-financial corporate sector, the measure that Greenspan watches most closely, rose at an annual rate of 5.4% in the first quarter, significantly faster than the 4.5% rate at the end of 2003.

Greenspan is a master at sorting through these conflicting data, adding to the mix the information he constantly receives from his wide-ranging contacts in the business community.

The evidence suggests that, despite worries about a bit of froth in some property markets, and concern about the rate at which the federal government is capable of spending money, he is satisfied that the economy is on a sustainable growth path, and that his policy of “measured” interest-rate increases is just the thing the economy needs to prevent inflation.

Which brings us to oil prices. The rise of crude oil prices to and above $65 (£36) a barrel, and of petrol prices to $3 a US gallon (£2 per UK gallon) in parts of the US, has fuelled inflation fears.

In the past, monetary policymakers have responded by raising interest rates. That was a mistake. “The simple-minded notion that because oil prices are going up you need to tighten would be a huge policy error,” said Harvard professor William Hogan, who has analysed every oil-supply interruption and price rise that has afflicted American consumers.

Given the ample slack in the global economy, he adds, it would be folly to tighten monetary policy in response to a rise in oil prices, rather than a jump in the general price level.

Indeed, other things being equal, the Fed would be tempted to loosen monetary policy to offset the drag created by the higher oil prices that are already causing some pain for Wal-Mart’s customers. But other things are not equal. Against the oil-price drag, policymakers must set facts pointing to continued growth this year and next:

• Consumers continue to spend. Parents plan to spend almost $50 billion to supply their children with clothes, books, computers and iPods for the new school and college terms;
• The housing sector is booming in response to growing demand;
• Businesses are awash with cash after nine consecutive quarters of double-digit profit growth;
• Unit labour costs, “which have typically been a key driver of inflation during periods of strong demand”, according to Business Week, are rising at the fastest pace in five years; and
• The rising trade deficit, and the desire of foreign central banks to diversify their reserves out of dollars, will eventually weaken the greenback, forcing up the price of imports and allowing domestic producers to raise prices.

My guess is that Greenspan won’t panic and accelerate the interest-rate increases he is planning in his hunt for a level that will neither speed up nor slow down economic growth. Nor will he abandon his current “measured” increases, at least not just yet.

He is unlikely to loosen policy to accommodate higher oil prices until he has a strong indication that the drag they create is overwhelming the growth-creating forces driving the economy.

Steady as she goes is likely to be the message, at least for now.

• Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute

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