Hold the Champagne

NYT Editorial

When this week’s government reports showed tamer inflation than had been anticipated, investors almost certainly overreacted, pushing up stocks and bonds as if all was right with the economy. A slowdown is certainly preferable to an overheating economy, which raises the likelihood of much higher interest rates and widespread unemployment. But a slowdown is still bound to be painful, especially for the Americans — and they are the majority — whose wages have been stagnating through much of the current economic cycle.

Investors’ jubilation was also likely a reflection of their own relief. This week’s evidence of decelerating inflation has vindicated the judgment of Ben Bernanke, the new chairman of the Federal Reserve, who decided last week to pause in the two-year-old campaign to raise interest rates. That display of acumen boosted investors’ confidence in his ability to correctly call the shots.

What the market doesn’t seem to be considering is the possibility of problems for which the Fed has no good answers. The depth and duration of an economic slowdown will depend in large part on the ultimate fate of the housing boom. As the housing sector continues to weaken, employment could take a big hit; the Economic Policy Institute calculates that housing-related jobs accounted for 15 percent of nation’s job growth in 2005. Consumer spending could also be affected, via higher unemployment, less home-equity borrowing and a general reversal in the wealth effect — that free-spending feeling people get when their assets are appreciating.

At the same time, the slowdown is likely to weaken the dollar. Theoretically, a weaker dollar should help the economy over time by increasing American exports. But that assumes that the economies of other countries will continue to chug along, even prosper, as the United States endures a slowdown. Moreover, the ill effects of a housing decline could soon be upon us, while the potentially beneficial effects of a weaker dollar would most likely need time to take hold.

The result could be a slowdown that is more severe than currently anticipated and that could be impervious to interest rate calibrations.

Of course, that is a scenario, not a prediction. The important point is that today’s economy has problems that go beyond price inflation. The last time the Fed successfully orchestrated a slowdown — in the mid-1990’s — the economy was not coming off a housing boom. The federal budget was heading toward the black, the trade deficit was a fraction of its current size as a share of the economy, and oil prices, while volatile, were relatively low.

Now is a time for watchful waiting, not uncorking the Champagne.