Tim Duy is worried:
Not a Pretty Picture, by Tim Duy: It is simply delusional to deny the impact of surging inflation on household spending. The April reading on consumer confidence pegs year-ahead inflation expectations at 4.8%, up from 3.4% just three months earlier in January and the highest since 1990. This is not good. True, the Fed can take comfort in the fact that long-term expectations continue to hover around 3%, but I would not become to complacent on that front. If the Fed continues to pursue policy that confirms agents near term inflation expectations, longer term expectations will rise accordingly. That would leave the weak job market as the last defense against a fundamental shift in the inflation regime. Let’s hope it won’t come to that.
Of course, the Fed sees inflation – it is all over the most recent minutes:
Real disposable personal income was unchanged in the fourth quarter, held down by higher food and energy prices, and moved up only slightly in January…
Household survey measures of expectations for year-ahead inflation jumped in March to their highest levels in about two years; in contrast, survey measures of longer-term inflation expectations were unchanged or up slightly…
Payroll employment declined substantially; oil prices surged again, crimping real household incomes; and measures of consumer and business sentiment deteriorated sharply.
Honestly, it is tough to justify the Fed’s continue description of inflation as merely “elevated” given their own descriptions of inflation in the minutes. And note the Fed remains hesitant to recognize its role in fostering higher inflation. They come close on at least one front:
Agricultural prices were rising at a substantial clip, partly in response to strong global demand, lean supplies, and a lower foreign exchange value of the dollar… the recent depreciation of the dollar could boost import prices and thus contribute to higher inflation.
They accept the inflationary consequences of a weaker Dollar, including the link to agricultural prices (and, presumably, energy prices). They then take comfort in the “anticipated … flattening of oil and other commodity prices,” seeming to ignore that their policy stance has something to do with the Dollar. Still, one cannot imagine that they do recognize this link. If so, they leave a pretty clear trail of breadcrumbs between their policy and recent “elevated” inflation rates – a clear enough trail that one would think they would be more cautious about pace of easing (or additional easing at all).
Interestingly, the sagging Dollar clearly elicited a stronger response from the G7 in this weekend’s communiqué, giving hope that the Fed is becoming more aware of the full implications of their policy stance:
Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability.
Presumably, both Fed Chairman Ben Bernanake and US Treasury Secretary Henry Paulson signed off on this language. So it is reasonable to conclude that the Fed is starting to get just a bit more concerned that their policy choices are having some unintended consequences. Of course, if the G7 was really concerned about exchange rate stability, they would put more effort into coordinating monetary policy than jawboning currency traders. Instead, G7 policymakers must realize the current state of affairs will continue (it is their decision, after all), particularly the policy gulf between the Fed and the ECB. Which means they expect ongoing pressure on Dollar, enough pressure to elicit stronger jawboning from the G7.
I anticipate jawboning will have its expected impact, at least initially, including a hit to commodities. When the novelty wears off, will the G7 resort to the more forceful tool of coordinated intervention? I honestly hope this does not devolve into an episode of the Fed easing policy on one hand and then intervening to support the Dollar with the other hand. I find those situations to be emotionally draining – like watching a friend in a self destructive pattern but being unable to help.
I fully appreciate the current policy dilemma Bernanke & Co. face – this is not your garden variety Keynesian slowdown. The yawning current account deficit represents consumption in excess of productive capabilities, and we are resolving that imbalance. The resolution entails accepting some moderation of domestic demand in concert with expansion of external demand that will be consistent with a new constellation of interest rates, exchange rates, and prices. It is not obvious, a priori, that we know the monetary policy consistent with that new equilibrium. But policymakers should realize that implications of that adjustment when setting policy.
My concern remains that the Fed has panicked in setting a rate policy that treats the external sector – and therefore, the current account adjustment – as a mere curiosity, giving little thought to their role in supporting the adjustment. In effect, policy, both monetary and fiscal, has degraded into an effort to dig the economy out of a hole by shoveling deeper. We built the most recent expansion on the back of debt financing, driving consumption gains while real median incomes stagnated on the theory that you can borrow your way to prosperity. That theory has proven ill-advised at best; the inability to continuously fuel the borrowing binge through housing provided the initial blow to the consumer. The second blow was the softening job market due to the first blow. The third blow was the inflation driven by the policy response designed to minimize the impact of the first two blows. The question now is: does the Fed read the increased pain of consumers as a reason to cut rates 50bp at the next outing of the FOMC? I hope not – but I cannot rule it out.
Then again – perhaps we are simply at the point where inflation is the only politically palatable option. The Bear Sterns rescue is the basis for a massive, fully monetized bailout of the financial sector…and Congress and the next President would oblige. If that is where we are headed, somebody needs to start thinking about capital controls before the rest of the world realizes the US intends to repay its obligations with very devalued Dollars.
Bottom Line: As has been the case for months, I would be much less concerned about the path of monetary policy in the absence of rapidly increasing commodity prices and a declining Dollar. I do not believe it is advisable to let the Dollar completely disintegrate. And given the increasingly clear link between monetary policy, the Dollar, and commodity prices, the Fed would be best to served to moderate the pace of easing. I think they understand this, but I remain worried that fundamentally, they only have one tool, and they will feel a need to keep using it if only to look like they are doing something. This is especially worrisome given that low interest rates are apparently not providing much of a fix for Wall Street – for that, the Fed needs to focus on reducing counterparty risk.