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Inflation? What inflation?

by Darrell Delamaide, Board of Contributing Editors

Inflation? What inflation?

In contradistinction to the European Central Bank, the Federal Reserve is putting on a masterful display of inaction over possible credit tightening, grounded on the real fear that an early exit from easy money could send the economy into a renewed tailspin. In the debate between the so-called ‘empiricists’ and ‘theorists’, the empiricist, or dovish, camp appears to have gained the upper hand.

All members of the Federal Reserve Board of Governors (currently six with one unfilled position) and all 12 heads of the regional Fed banks take part in the regular monetary policy meetings of the Federal Open Market Committee, but the only ones who vote are the governors, the NY Fed chief and four other regional bank heads in a three-year rotation. Fed governor Kevin Warsh announced his resignation in February, which would create two open positions on the board pending Senate review of MIT professor Peter Diamond’s nomination.

Bernanke says inflation will remain ‘modest’

In his twice yearly testimony to Congress on 1 March, Federal Reserve Chairman Ben Bernanke (voter) acknowledged surging oil and food prices, but said that inflation would likely remain tame. Confirming that an interest rate hike does not appear to be on the cards for the time being, Bernanke said, ‘My sense is that the increases we’ve seen so far -- while tough for many people -- do not yet pose a significant risk to the overall recovery.’ Speaking before the Senate Banking Committee, Bernanke noted that rising commodity prices will probably be passed on to consumers, but this effect would be only ‘temporary and relatively modest.’

But he acknowledged that if higher prices persist, inflation could become a serious risk. ‘Sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability,’ he said. The Fed projects inflation of less than 2% for each of the next three years. As a while, the Fed seems to believe that surging energy and food prices are more likely to hit business confidence than spark a spiral of price rises.

Dudley cautions against overreacting on commodity prices

The US Federal Reserve should be careful about overreacting to the recent spike in commodity prices, the No. 2 Fed policymaker said in a speech at the end of February. William Dudley (voter), president of the New York Fed and vice chairman of the FOMC, said that the recent rapid increase in commodity prices is likely to be temporary. ‘Much of the most recent rise in food prices is due to a sharp drop in production caused by poor weather rather than a surge in consumption,’ Dudley said in a speech at New York University.

He acknowledged that if in fact demand in emerging economies led to persistent commodity price increases, they could start to ‘seep’ into core inflation. ‘If commodity price pressures persisted, this could undercut one rationale for focusing on core measures of inflation – the argument that core measures are better predictors of future headline inflation than today’s headline rate,’ he said. The Fed has successfully kept inflation expectations well anchored since the mid-1980s, Dudley said, by focusing on core inflation and ignoring the effect of volatile food and energy prices. But the US central bank would not tolerate any increase in medium-term inflation expectations, he said. Dudley sounded a familiar Fed theme in noting that the situation in the US is different from that in much of the rest of the world. ‘Relative to most other major economies, the US inflation rate is lower and the amount of slack much greater,’ he said.

Plosser less certain about prices

Another Fed official is less sanguine about the implications of commodity price increases for US inflation. ‘It is likely that much of the rise in global commodity prices is driven by increased global demand,’ Philadelphia Fed president Charles Plosser (voter) told the Rotary Club in Birmingham, Alabama, taking a contrary view to that of Dudley.

And these higher commodity prices could pass through into core inflation, Plosser said. ‘If a country’s monetary policy remains very accommodative, it will ultimately permit the prices of other goods and services to rise along with commodity prices, resulting in higher inflation rates,’ he said.

Recent data suggests that last year’s concerns about deflation, which he never shared, are a thing of the past, Plosser said. For the coming year, he expects inflation in the US to reach the 2% level that the Fed does not want to exceed. In that context, further strengthening of the economy would indicate it is time for Fed officials ‘to begin taking our foot off the accelerator,’ Plosser said, and begin tightening monetary policy.

In particular, it might become advisable to bring to an ‘early close’ the Fed’s most recent asset purchase programme of $600bn of longer-term Treasury securities, due to end in June, Plosser said. Despite his own misgivings about the benefits of the programme, he has supported continuation because ‘it is generally a good practice for a central bank to do what it says it is going to do.’

But if circumstances should significantly change, the Fed must take seriously its own commitment to review the programme periodically and make appropriate adjustments.

‘Every hundred billion counts’

Some commentators have wondered why there seems to be a debate about curtailing QE2 when it runs out in June anyway, but, as Richmond Fed president Jeffrey Lacker (non-voter) noted in a CNBC interview ‘every hundred billion counts.’ For him, what matters is when the Fed signals to the market that it is ready to begin monetary tightening if necessary in the face of a strengthening economy and rising inflationary expectations. ‘I don’t want to move that starting line too far back,’ he said in an interview ahead of a monetary policy conference in New York.

Lacker said it made more sense to him to stop or unwind the asset purchases before making any move on interest rates to first see what effect the reduction of bank reserves has on interest rates. With regard to the spike in oil prices due to unrest in the Middle East, Lacker said the price rises so far don’t threaten to derail the US economic recovery. The increased prices at this point seem ‘manageable,’ he said, and don’t seem likely to pass through to core inflation.

In a separate appearance on CNBC, St. Louis Fed chief James Bullard (non-voter), a big backer of QE2, also suggested that the Fed might curtail the asset purchases. ‘I would see it as possibly finishing the program a little bit shy of where we intended initially then go on pause for a while, let more information come in on the economy, see how things develop,’ Bullard said, in describing monetary policy as a continuous policy.

‘If things continue to go as well as I think they will in 2011 then we can start the process of getting the balance sheet back to normal and getting interest rates up there eventually.’

Romer wades into Fed debate on QE2

Now that she has been passed over to replace Janet Yellen as president of the San Francisco Fed, Christina Romer waded into the debate about quantitative easing as economic stimulus in a recent op-ed article in the New York Times, ‘The Debate That’s Muting the Fed’s Response.’

The economist at the University of California-Berkeley, who just spent the better part of two years as chairman of the Council of Economic Advisers, first re-defined doves and hawks as ‘empiricists’ and ‘theorists’ and then firmly situated herself in the empiricist, or dovish, camp.

Empiricists, Romer argued, look at the evidence and see that inflation historically poses little danger when unemployment is high. Theorists, on the other hand, worry that inflation can result from market expectations when the Fed sends the wrong signals about its commitment to price stability.

In the debate about the Fed’s asset purchase programme, ‘the main division is between the empiricists who say “inflation is unlikely at 9% unemployment” and the theorists who say “inflation could bite us at any moment.”’

As a consequence, the Fed, in her view, in paying heed to the theorists’ view, is missing an opportunity to provide a more robust stimulus to the economy, as President Franklin Roosevelt was willing to do when he risked creating inflationary expectations in his fight against the Great Depression.