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July 2006

Some opposite view in contrast to market’s reaction last week on Bernake’s comments. Also attached is a link to Cecchetti’s view on current state of inflation. I happened to believe also the Fed raised the interest rate too slow back in 2003-05.

The Fed’s Logic
appeared on wsj

Every investor likes to believe that the bad news is behind him, so stocks understandably soared yesterday on Fed Chairman Ben Bernanke’s allegedly dovish testimony to Congress on the future course of interest rates. For our money, however, yesterday’s bigger and less reassuring news was the Commerce Department’s June inflation report.

The June consumer price index proved, if more proof were needed, just how big a monetary policy mistake the Fed made from late 2003 through 2005. The government’s price indices operate on a lag, often as long as 24 months, and they are now showing a marked inflation revival that too many economists and pundits, including more than a few Fed Governors, have been reluctant to acknowledge.

Overall prices rose in June by 0.2%, a deceptively low number since it included a big decline in energy prices for the month; the real signal is that inflation has set in across the breadth of the U.S. economy. For the last 12 months prices have climbed at an annual rate of 4.3%, and for the last three months by 5.1%. So-called “core” inflation — sans food and energy — rose 0.3% in June and is now well above the 2% annual rate that the Fed says is at the top of its tolerable range. For the last three months, “core” inflation is up a scary 3.6%.

So when Mr. Bernanke declared in his testimony yesterday that “Inflation has been higher than we had anticipated in February,” he was understating things by a good measure. The Fed has been wrong for a lot longer than February; it has merely taken the conventional price indices this long to make some people believe it.

One striking, and perhaps worrying, part of Mr. Bernanke’s testimony yesterday was his implicit logic that real economic growth will soon slow down, therefore we don’t have to worry about inflation as much, ergo interest rates may not have to keep rising. Mr. Bernanke is too good an economist to actually believe this . Real GDP growth (defined as growth less inflation) can decline even as prices are rising fast and nominal growth continues to roar. What the Fed should be watching is less real GDP than real prices, and this is where the Fed took its eye off the ball by staying too loose for too long.

Mr. Bernanke is still scrambling to catch up, and the danger looking ahead is that the Fed will have to raise rates more than if it had tightened money faster and earlier in the final years of the Alan Greenspan era. Investors in stocks were betting yesterday that the interest-rate increases are almost over, though we wouldn’t bet our own mortgage on it. Stocks were also perhaps oversold last week due to Middle East worries. More price increases are baked in the cake in coming months, and those will surely test whether the Fed can make its much-ballyhooed “pause” in raising rates at its August meeting — and for how long.

Our own belief is that the Fed has substantially increased the chances of a recession in the next year or two by failing to blunt inflationary expectations early enough. Let’s hope the economy’s current supply-side momentum, led by very strong business investment, and stronger global growth will offset the impact of higher rates and $75 oil. Monday’s Fed report of a big 0.8% jump in June industrial production was an encouraging sign that business spending and manufacturing remain strong.

One question for the Fed, and especially for its staff, is whether its inflation mistake will lead to any policy introspection. Mr. Bernanke is surely right, as he said yesterday, that “monetary policy makers operate in an environment of uncertainty.” But those policy makers also continue to downplay, or even dismiss, the relevance of such real-time inflation signals as a weak dollar and the soaring price of commodities including gold. Those prices have been warning the Fed about future inflation for a long time. Some policy reflection can be good for the soul, and even better for the economy.

Link to Steve’s most recent inflation update:


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