Fed Wary of Inflation, Preparing Rate Increase: John M. Berry
Oct. 4 (Bloomberg) -- Federal Reserve officials' credibility as inflation fighters, firmly established by good inflation performance in the 1990s, has allowed them the luxury of taking their time in responding to monthly blips in inflation rates.
Even a string of bad numbers no longer sets bond market vigilantes howling for Fed scalps and bidding up interest rates.
That doesn't mean officials are relaxed about inflation.
Right now they are constantly checking whether surging energy prices might be pushing up core inflation. Even more importantly, they are on the watch for any sign that expectations for future inflation are deteriorating.
Unfortunately, they seem to have seen at least a few, and that means they are on track to raise their target for the overnight lending rate again, to 4 percent, on Nov. 1.
An indication of that surfaced in the statement issued after the Sept. 20 meeting of the Federal Open Market Committee, which said the committee concluded that ``longer-term inflation expectations remain contained.'' That was a distinctly sobering step back from the members' view at the Aug. 9 meeting, when they regarded such expectations as ``well contained.''
And of course the committee said once again that it ``believes that policy accommodation can be removed at a pace that is likely to be measured.'' That language also points to another rate increase next month.
Focus on Inflation
In speeches last week, two Fed officials explained why they are so focused on inflation expectations.
In one, Fed Governor Donald L. Kohn told a Washington conference that a major change since the early 1970s in economists' views of inflation was the acceptance of Milton Friedman's point that ``any tradeoff between inflation and unemployment is only temporary because of the dynamic nature of expectations. We have also taken on board the practical application of this lesson that monetary policy must be vigilant about anchoring inflation expectations.''
The Fed's success in doing that has increased investor patience when some bad inflation numbers come along. It has also increased patience when the amount of slack in the economy has shrunk to levels that in the past had caused inflation to take off. That was true, for example, in the late 1990s when the U.S. unemployment rate fell to 4 percent. Markets stayed calm and inflation remained low.
This success may have created a potential difficulty for the Fed and made it even more imperative that inflation expectations be kept under control, Kohn said.
Costly Corrections
``Imbalances between demand and potential supply would thus be slow to show through convincingly to inflation, but when they do, they may be costly to correct,'' he said.
That is, were inflation to accelerate to an unacceptable level, it would be harder to bring it down again than in the past.
Kohn said the Fed staff now uses a ``rule-of-thumb estimate'' of the so-called sacrifice ratio that is 4-to-1 instead of the 2- or 3-to-1 of the past. That is, it would take an increase in the unemployment rate of 4 percentage points for a year to lower the inflation rate by 1 percentage point, if you started from full employment.
Given that the Fed also has a mandate to maximize employment, officials simply don't what to take the risk of letting inflation expectations rise and allow inflation get out of hand.
Energy Passes Through
In another speech on Sept. 27 in London, Janet L. Yellen, president of the San Francisco Federal Reserve Bank, said that some of the recent rise in energy prices may get passed through to other goods and services.
``However, a more persistent increase in inflation, such as was witnessed during the 1970s, seems unlikely as long as inflation expectations remain well contained,'' she said.
In that decade, ``higher oil prices touched off a wage-price spiral which was costly to unwind,'' Yellen recalled. ``In contrast, U.S. experience since the early 1980s reveals no evidence of pass-through from real energy prices to core inflation. The crucial difference seems to be that, during the 1970s, the public's inflation expectations became unmoored from price stability, whereas, since the early 1980s, they have been well-anchored.''
Yellen expressed some confidence that core inflation may ``actually fall a bit over the next two years'' and settle in the middle of her 1 percent to 2 percent comfort zone.
`Front and Center'
Economist Robert V. DiClemente of Citigroup Inc. told his clients on Sept. 30 that the issue of inflation expectations ``is front and center now.''
``Although underlying inflation is not unacceptable, core measures are running high within oft-cited boundaries of price stability at a time when policy is still accommodative, labor markets are tightening and a relentless rise in energy prices is challenging inflation expectations,'' DiClemente said.
With that challenge, ``the Fed does not have the freedom to pause and may have to risk at least a mild overshoot, especially in the absence of tighter financial conditions,'' he said.
The Kohn and Yellen speeches, and public comments by several of their colleagues, suggest agreement with that assessment.
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