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Well, what do you expect?

Posted by iBlog on July 6, 2008

FOR the first time since the credit crisis began, the Federal Reserve’s open-market committee decided to keep American interest rates on hold. In a statement released after its policy meeting on Wednesday June 25th the Fed said the dangers to GDP growth had “diminished somewhat” but conceded that the continued rise in energy prices meant the risks of inflation had increased.

This was a shift in judgment, if a subtle one, about where the biggest threat to America’s economy lies. But there was no hint that higher interest rates are imminent. Richard Fisher, the president of the Dallas Fed, was the only member of the ten-strong rate-setting committee to vote for a rise.

After a series of cuts since the summer, the fed-funds rate, at 2%, looks uncomfortably low when set against headline inflation at 4.2%. Yet the Fed seems confident that inflation will moderate. One reason is that higher inflation reflects a jump in the cost of oil and food rather than a broad acceleration in prices. When commodity prices shoot higher, the standard policy response is to treat the resulting rise in inflation as a once-and-for-all shift in relative prices. An interest-rate increase big enough to squeeze inflation back down in short order would cause a needlessly large rise in unemployment.

As long as the public believes the Fed will act to control inflation, today’s price increases are unlikely to feed tomorrow’s wage claims, and a wage-price spiral can be averted. The trouble is, expectations of inflation have started to pick up. A survey by the University of Michigan shows that inflation is expected to be over 5% in the next year, the highest reading since 1982. And expected inflation for the next five to ten years is 3.4%, the highest since 1995. This trend is mirrored in other rich countries. In Britain expectations have risen to their highest level since the central bank’s survey began in 1999. A poll of the euro area, carried out by the European Commission, also shows a rise in the balance of consumers expecting higher inflation.

Until recently, central bankers have looked on the stability of inflation expectations with satisfaction. The public seemed to trust that independent monetary stewards would not be tempted, as politicians might be, to keep interest rates too low to control inflation. But now that faith is in doubt, policymakers seem to be shifting tack. The Fed’s statement referred to a pick up in “some” indictors of expectations but reckoned that this was a sign only of greater “uncertainty” about the outlook. In a speech on June 9th Ben Bernanke, the Fed chairman, admitted to gaps in knowledge about how the actions of central banks affect inflation expectations and how these in turn have a bearing on inflation. Such qualifications are a hint that inflation expectations may have lost their place at the heart of policymaking.

One reason not to worry is that perceptions often differ from reality. Consumers may be overly sensitive to changes in the price of frequent purchases, such as food and fuel, while they overlook the stability of other prices. As the effect of the commodity shock fades, expectations are likely to follow recorded inflation back down again.

If, however, an inflation psychology is returning, not all the rich world’s central bankers appear to be treating it with the same degree of trepidation. The European Central Bank has signalled that it will raise interest rates at its next meeting on July 3rd, to show that inflation remains its main concern. That the central bankers at its American counterpart are sitting on their hands, for the moment, reflects the greater threat of a sharp downturn in the economy there. But if the Fed’s rate-setters are too complacent about rising inflation expectations, they run the risk of squandering the credibility their predecessors earned at such a high price.

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One Response to “Well, what do you expect?”

  1. […] Read the rest of this great post here […]

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