The Federal Reserve debates inflation

With so much heated debate and discussion about inflation in the media these days, I thought I would focus on how the Federal Reserve discussed and debated inflation in the latest meeting minutes released today.

The Federal Reserve’s staff economists concluded that while commodity prices have increased substantially and near-term inflationary expectations have also increased, the outlook for medium and long-term inflation remained stable. In other words, current inflationary pressures should prove “transitory.”

“Sizable increases in prices of crude oil and other commodities pushed up headline inflation, but measures of underlying inflation were subdued and longer-run inflation expectations remained stable…

…According to the Thomson Reuters/University of Michigan Surveys of Consumers, households’ near-term inflation expectations increased substantially in early March, likely because of the run-up in gasoline prices; longer-term inflation expectations moved up somewhat in the early March survey but were still within the range that prevailed over the preceding few years.

…Measures of inflation compensation over the next 5 years rose, on net, over the intermeeting period, with most of the increase concentrated at the front end of the curve, likely reflecting the jump in oil prices. In contrast, measures of forward inflation compensation 5 to 10 years ahead were little changed, suggesting that longer-term inflation expectations remained stable.

…The staff revised up its projection for consumer price inflation in the near term, largely because of the recent increases in the prices of energy and food. However, in light of the projected persistence of slack in labor and product markets and the anticipated stability in long-term inflation expectations, the increase in inflation was expected to be mostly transitory if oil and other commodity prices did not rise significantly further. As a result, the forecast for consumer price inflation over the medium run was little changed relative to that prepared for the January meeting.”

Some Federal Reserve members expressed their concern that current inflationary pressures may still lead to upward pressure on long-term expectations:

“…participants observed that rapidly rising commodity prices posed upside risks to the stability of longer-term inflation expectations, and thus to the outlook for inflation, even as they posed downside risks to the outlook for growth in consumer spending and business investment.”

InflationWatch has chronicled numerous instances of companies that either plan to or already have passed on price hikes to consumers. The Federal Reserve is also noticing, but their “contacts” are apparently not confident that plans for price hikes can stick:

“A number of business contacts indicated that they were passing on at least a portion of these higher costs to their customers or that they planned to try to do so later this year; however, contacts were uncertain about the extent to which they could raise prices, given current market conditions and the cautious attitudes toward spending still held by households and businesses.”

I often whether in these circumstances whether the Federal Reserve passes on some “friendly” advise to these contacts…

The most common reason cited for assuming inflation will remain tame is that there remains a large amount of slack in resource utilization in the economy. Someone on the Fed recalled an important exception to such assumptions:

“Some participants pointed to research indicating that measures of slack were useful in predicting inflation. Others argued that, historically, such measures were only modestly helpful in explaining large movements in inflation; one noted the 2003-04 episode in which core inflation rose rapidly over a few quarters even though there appeared to be substantial resource slack.”

One way to keep inflation expectations anchored is to insist that it will stay anchored. Ben Bernanke has planned to do press conferences, and the rulebook assurances over inflation may be part of the motivation:

“A few participants noted that the adoption by the Committee of an explicit numerical inflation objective could help keep longer-term inflation expectations well anchored.”

Finally, the topic of the Federal Reserve’s balance sheet came up. I have long maintained that the Fed will find itself unable to wind down this balance sheet quickly or in a timely fashion. Some on the Fed are afraid that more people like myself will harbor these same doubts:

“…a few participants noted that if the large size of the Federal Reserve’s balance sheet were to lead the public to doubt the Committee’s ability to withdraw monetary accommodation when appropriate, the result could be upward pressure on inflation expectations and so on actual inflation. To mitigate such risks, participants agreed that the Committee would continue its planning for the eventual exit from the current, exceptionally accommodative stance of monetary policy.”

This path toward an exit is likely fraught with monetary perils and should provide a lot more volatility in financial markets. Stay tuned.

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