Should the Fed Be Worrying About Inflation – Or Not Yet?

As long time readers of this blog know (both of you), I have been worried about the risk of inflation for a long time, and it hasn’t happened – until maybe now. 

In March of 2008, I worried that the Federal Reserve might, by lowering interest rates too much in an effort to stimulate the economy, stimulate inflation instead.  In April of 2009, I worried about Quantitative Easing I (though at the time, obviously, we did not know it was “I”).  In July of 2009 I questioned Ben Bernanke’s ability to take liquidity out of the economy on a timely basis when economic activity picked up.  In October of 2009, I asked whether the Fed’s flooding of the economy with liquidity would create a bubble in the stock market.  Finally, in November of last year (here too), I worried about whether Quantitative Easing II would result in a bubble.

Clearly, my worries about inflation in 2008 and 2009 were wrong.  On other hand, my concerns about Quantitative Easing and possible bubbles may not have been off the mark as much.  The stock market has jumped since April of 2009.  Some of it is clearly a result of an improvement in the economy.  Some of it may be a result of the fact the April 2009 was too low, an overreaction on the down side.  The question is whether there is some bubble in the current stock market.  I don’t know, and the problem is we probably won’t be able to know until after it has burst.

There are some who feel that QE II has played a big part in the recent rise in food, oil and commodities prices.  Look at the chart that Russ Winter posted at Minyanville.  While there could be other reasons for what happened, there does appear to be some correlation here.  Which may mean it is time to start worrying about inflation again.

Certainly, food prices are up.  Gas prices are up.  But Ben Bernanke and others at the Fed tell us not to worry.  “Core inflation,” which doesn’t include food and energy prices,* is still below the Fed’s informal target of 2% per year.

“Most Fed officials are comfortable with keeping rates close to zero as long as inflation expectations don’t rise ….

Fed Vice Chair Janet Yellen Monday vowed the U.S. central bank won’t repeat the mistakes of the 1970s, when high oil prices led to sharp increases in consumer prices. As long as inflation expectations remain stable, the increases seen so far in global commodity prices and headline inflation are unlikely to lead to the wage-price spiral seen in the past, she said.” (Here)

The Fed says it doesn’t need to worry about inflation because people and businesses aren’t worried about inflation.  “[L]onger-run inflation expectations remain well anchored,” according to Janet Yellen.  "If inflation expectations became unanchored, the Fed would have to respond. I don't see any signs that expectations are becoming unanchored," [New York Fed President William] Dudley said.

Here is my concern:  By the time the Fed realizes that long-run inflation expectations are no longer anchored, it will be too late.  It will take the Fed a while to realize it has happened.  They won’t agree on the signs.  Some will focus on things like unemployment or a sluggish economy, etc., and won’t see the change in inflation expectations.  By the time that enough Fed governors agree that they need to do something, it could be expectations of higher inflation that will be well-anchored.  As we learned in the 1970s and early 1980s, once inflation is in the economy, it is hard, and painful, to wring expectations of further inflation out of the economy.

The problem with using long-term inflation expectations as the guide is that it tells you too late.  To keep inflation out of the economy, you have to act to prevent inflation before people expect it.  Once they expect it, it is too late.  It is already there.  You don’t want to have to wring inflation out of the economy; you want to keep it out in the first place.  Relying on expectations of inflation to tell you when to act greatly increases the chances you won’t act until it is too late.

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* Many economists exclude food and energy prices from inflation calculations because they are so volatile that they can skew things one way or the other.  Also, the idea is that increases or decreases in food and energy prices can be fleeting and don’t affect overall price levels.

Comments

[Jennie]

In the opinion of a longtime reader (probably the initial reader due to my advanced internet skills), this is a good post.