Inflation Still The Fed’s Main Concern
By Jason Simpkins
Despite an abysmal housing market and a timid stock market, inflation remains the chief concern of Federal Reserve Chairman Ben S. Bernanke.
In a speech he made in Cambridge, Mass., yesterday, Bernanke provided little insight as to the near-term intent of the Fed regarding interest rates, or its assessment of the inflation outlook. But he made some very interesting observations on the importance of managing investor sentiment.
“Experience suggests that high and persistent inflation undermines public confidence in the economy and in the management of economic policy generally,” Bernanke said.
Bernanke made his comments at the Monetary Economics Workshop of the National Bureau of Economic Research (NBER) Summer Institute.
With comments like that, Bernanke is making it clear that he understands how important it is to factor public sentiment into the Central Bank’s evaluation of the environment for inflation and interest rates. But even more crucial is that Bernanke realizes the Fed must actively manage investor expectations, thereby avoiding the nasty market reactions that result from “negative surprises” – unforeseen bad news, or events such as a necessary interest-rate increase that could have been telegraphed to investors, but that wasn’t.
Bernanke said that inflation expectations “greatly [influence] actual inflation and thus the Central Bank’s ability to achieve price stability.”
Inflation – a persistent and pernicious increase in the level of general prices throughout a specified market or nation – has been viewed as U.S. Public Enemy No. 1 by the Federal Reserve since the time of Fed Chairman Paul A. Volcker, who headed the central bank from August 1979 to August 1987.
Since the end of Volcker’s term, and during virtually all of successor Alan Greenspan’s stewardship, inflationary pressures have been largely absent, which makes it possible for an economic system to absorb such inflationary pressures as soaring oil prices – at least for a time.
The current outlook stands in stark contrast to the United States’ experience of the 1970s, when spiraling energy prices from two separate gasoline shortages, recessionary pressures and high unemployment combined to feed into a mystifying mixture known as “stagflation.” Until that happened, economists had thought it impossible to have high inflation at the same time there was high unemployment and a recessionary economy. It took the nation years to break free of stagflation’s clutches.
Presently, the Fed’s key interest rate has been held at 5.25% for more than a year, and Fed policymakers held rates steady at their last meeting, which was at the end of June.
Prior to this stretch of interest-rate stability, the Fed had increased interest rates for two years running in an effort to stave off the effects of inflation. That was the longest uninterrupted stretch of interest-rate increases – meaning there were no intervening rate cuts – since the central bank first appeared.
Toward the latter part of June, Bernanke acknowledged improvements in some of the barometers used to test the current climate for inflation, but also said “a sustained moderation in inflation pressures has yet to be convincingly demonstrated.”
Therefore, Fed policymakers continue to assert that inflation remains the U.S. economy’s greatest potential enemy – if it fails to recede as they anticipate. The Fed has focused the majority of its energy discussing the benefits and consequences related to “inflation targeting.”
“We’re making very good progress,” Bernanke said, “And I hope we’ll be able to come forward in the reasonably near future with some suggestions and ideas.”
No specifics concerning the nature of said ideas, or any specific timetable relating to their conception, was remarked upon, however.
But in another scenario, Bernanke and the Fed could end up in a tough spot. While the central bank has been holding rates steady, and many economists are calling for the start of rate reductions before the end of the year, global forces could render all that impossible.
The U.S. dollar continues to weaken against rival currencies. Indeed, while Bernanke was speaking yesterday, the European euro shot up to an all-time high against the dollar. And the British pound sterling continues to trade near 26-year highs against the dollar.
The British central bank raised short-term rates by a quarter point to a six-year high of 5.75% last Thursday, its fifth increase in a year as it tries to tamp down nagging inflation. At the same time, the European Central Bank held rates steady at 4%. However, the ECB is reportedly considering a quarter-point increase for September.
Currency traders were greatly discouraged by downbeat housing-market forecasts, by continuing increases in oil prices, as well as by troubling financial reports from some key U.S. retailers, including one-time Wall Street darling Home Depot Inc. (NYSE: HD), and Sears Holdings Corp. (Nasdaq: SHLD). Sears’ shares dropped nearly $17 each, or almost 10%, yesterday after releasing “guidance” on future financial results that left investors, well, less-than-satisfied.
Since consumer spending accounts for 60% to 70% of economic activity in the United States, hints of a slowdown in that area can be very disheartening – as well as an indicator of looming softness.
Most U.S. economists believe the Fed will keep short-term rates where they are for the rest of this year.
But with all the focus Bernanke placed on the need to manage investor expectations during his speech yesterday, one can’t help but wonder if the U.S. Fed chief isn’t already doing just that – laying the groundwork for the disappointing news that inflation is a problem, and that a weak dollar and higher interest rates abroad will make it necessary to soon start raising U.S. rates anew.
Bernanke told his audience at the NBER that “a deeper understanding of the determinants and effects of the public’s expectations of inflation could have significant practical payoffs," and noted that additional research on this topic would be most welcomed.
Founded in 1920, the NBER is a private and nonprofit research group that studies economics, with a special focus on the U.S. economy. It is best-known for its work on business cycles, and particularly for determining the start and end dates for U.S. recessions.
(You can find the full text of Bernanke’s remarks here.)
