If dollar declines too far, inflation may return, Volcker warns

Inflation could once again become a serious problem in the United States, warns Federal Reserve Board chairman Paul Volcker. Alarmed by rising import prices caused by a falling dollar and oil prices higher than last year's, Mr. Volcker says ``the danger is clearly out there'' that inflation can once again become a problem.

Volcker, in congressional testimony before the Joint Economic Committee Monday, said, ``My concern is that when you get pressures this year, which are more or less inevitable from rising import prices, and higher oil prices - if that's maintained ... the consumer price index won't look as good.''

In fact, Volcker was unusually explicit in laying down the dangers of currency depreciation. He pointed out, ``... a declining dollar at some point has high costs and risks as well. It generates inflationary pressures.''

If inflationary pressures were to mount, Volcker indicated the Fed might have to raise interest rates. He said, ``Clearly, renewed inflationary pressures and weakness in the dollar [on foreign exchange markets] would be factors limiting our flexibility,'' he said.

Volcker's position has wide ramifications, especially in the financial markets that have been buoyant recently. Immediately after Volcker's testimony, bond prices on Wall Street dropped and yields rose.

Some Wall Street Fed watchers interpreted Volcker's comments as an indication of potentially higher interest rates in the weeks ahead. ``He did a good job signaling what his position is,'' says Lincoln Anderson, an economist with Bear Stearns & Co. Inc., a Wall Street brokerage house.

This position, says Robert Dederick, economist at Northern Trust Co. in Chicago, had partly been sniffed out on Wall Street where it is expected that the Fed will not ease interest rates until later in the quarter.

``The Fed is signaling that a dollar under pressure is no time to ease interest rates,'' comments Mr. Dederick.

Although Volcker has issued other inflationary warnings, Dederick notes, the Fed chairman is now more blunt. Volcker particularly singled out price increases in the service sector that now constitute about two-thirds of the gross national product. Productivity increases in services, he pronounced, ``are zilch basically, if one believes the figures.'' Volcker pointed to medical and educational services where he said the inflationary trend ``remains quite strong.''

The Fed chairman has stated his concern about the falling dollar. He was, however, unusually candid about the inflationary dangers, telling Congress the danger level has been reached. In order to close the trade gap, he told Congress it would be necessary to reduce the budget deficit. As Volcker sees it, the relationship between the two is that the US will have to increase its industrial output by 15 to 20 percent to export more. This will require more investment in plants and equipment and more capacity.

To expand, the private sector must borrow. To Volcker, the greatest potential source of savings is in cutting the budget deficit. Without such cuts, he warned, ``It's difficult to see how we could manage to reduce the trade deficit, and with it the net capital flow from abroad, without jeopardizing growth, progress toward lower interest rates, and financial and price stability abroad.''

To cut the budget deficit, Congress is considering different ways to raise revenues including a variety of user fees and other tax hikes. One idea that has been suggested is an oil import fee. Volcker did not disagree, noting, ``It's an obvious place to look.''

Although Volcker believes the US must cut its deficit to solve its trade problem, he also maintains the US trading partners need to do more to stimulate their economies. Despite West German and Japanese interest rate cuts, he added, ``I wonder if they have done enough.'' He also singled out Taiwan for erecting barriers, and he castigated the Japanese, as well: ``I don't think the Japanese have an open market in the least.''