Friday, February 22, 2008

Fed to Act if Inflation Turns Sour

US Federal Reserve is Ready to Act if Inflation Turns Worse Despite Pressure of Recession.

How stable are inflation expectations in the US? This is the key to understanding how far the Federal Reserve will be able to go in cutting interest rates to stave off recession. As this week's minutes show, the Fed views the latest inflation data as "disappointing". Inflation reached an annual rate of 4.3 per cent in January, with the underlying core rate at 2.5 per cent.

The central bank is willing to look past the inflation numbers and focus on fighting recession risk, in part because it believes that economic weakness will ultimately moderate price ­pressures. But there is a caveat. The Fed will tolerate higher inflation only as long as it believes this is not seeping into inflation expectations and fostering a 1970s-style inflationary psychology.

That is the real stagflation risk - not a few months of weak growth and relatively rapid price increases. As Fed governor Frederic Mishkin said in a recent speech: "The flexibility to act pre-emptively against a financial disruption presumes that inflation expectations are firmly anchored."

The awkward fact is that market-based measures of inflation expectations have been moving up for a while. Crude comparisons of the difference in yield between ordinary Treasury bonds and Treasury inflation-protected securities show little change.

But these measures do not take into account the jump in the liquidity risk premium since the start of the credit crisis, which increased the attractiveness of more liquid ordinary bonds. Adjusting for this, the Cleveland Fed calculates that the inflation rate the market expects to prevail over the next 10 years has risen sharply, from 2.3 per cent at the end of July last year to 3.2 per cent today.

Using a different approach, Macroeconomic Advisers estimates that the inflation rate expected to prevail over a five-year period starting five years from now has gone up from roughly 2.5 per cent last spring to 2.96 per cent today.

Some survey-based measures of inflation expectations have also edged up, although they remain much more ­stable than market-based measures. "Recent data on inflation expectations are not all that reassuring," says Stephen Cecchetti, a professor at Brandeis university.

The Fed minutes argue that the market-based measures may exaggerate the move-up in expected inflation. Changes in recent months "probably reflected at least in part increased uncertainty - inflation risk - rather than greater inflation expectations".

However, economists say this would still be worrying, as it implies that investors do not think inflation expectations are very firmly fixed. The minutes say these expectations remain "fairly well anchored". But Goldman Sachs detects a "persistent concern" about the need to monitor them.

Larry Meyer, chairman of Macroeconomic Advisers, says the move-up in market-based inflation expectations is "cautionary". He believes the rise to date would not prevent the Fed from cutting rates again in March. But a significant further increase - or an equivalent move up in the survey-based measures - would be hard for the central bank to stomach.

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