An article from The economist.....good read ....source: http://www.digitaldalalstreet.com
The Fed has more to fear from inflation than from slower growthIT WOULD win no prizes for elegant prose, but the statement that accompanied the Federal Reserve's latest quarter-point increase in interest rates on May 10th was at least clear. The central bankers are not sure what to do next. Further policy firming may yet be needed to address inflation risks, they said, but they added that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.
The Fed's desire not to tie itself down is understandable. After 16 consecutive rate increases, American monetary policy is no longer loose and there are signs that areas of the economy that are sensitive to interest rates, notably the housing market, are feeling the effects of dearer money. Virtually all economists predict slower economic growth in the months ahead, a view given credence by April's surprisingly modest pace of job creation. Because higher interest rates take a while to show their full effect, prudence suggests a pause. Otherwise the central bankers risk slowing demand too sharply.
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That said, the economy has hitherto been roaring along at a wholly unsustainable pace: output grew at an annualised rate of 4.8% in the first quarter of the year. Both labour and product markets are tight, global growth is looking ever stronger, commodity prices are soaring, the dollar is falling, and American inflation is already pressing against the limits of the tolerable.
The Fed's favourite measure of inflation, the annual increase in the core personal consumption expenditure (PCE) deflator (ie, excluding fuel and food), rose in March to 2%the most that Ben Bernanke, the Fed's newish chairman, feels comfortable with. On balance, the chances are that, over the next few months at least, the Fed will worry more about inflation than about slower growth.
Short-term technicalities provide one reason for this. Arithmetical nuances alone suggest that the 12-month core PCE deflator will hover around, or even exceed, 2% for a while. More important, the housing component of core inflation, which is based on rental prices, is rising.
A core inflation rate temporarily above 2% need not automatically raise red flags. It has exceeded that threshold several times in recent years. And, as economists at Goldman Sachs have pointed out, the Federal Reserve stopped raising interest rates in early 1995 and mid-2000 despite a modest rise in core inflation. Then, however, the general trend of inflation was downwards; now it is rising.
Then there are worries about Mr Bernanke's credibility. Wall Street is still getting used to the shift from Alan Greenspan. The markets may well become unusually nervous about the Fed's commitment to fighting inflation if it stops raising interest rates when core inflation is at or beyond a threshold with which Mr Bernanke himself is clearly associated.
Already there are signs that people expect higher inflation to persist. According to the University of Michigan's gauge, expectations for inflation over the next five to ten years edged up to 3.1% in April, slightly higher than the average of 2.9% in 2005. The expected inflation rate implied by the prices of indexed ten-year Treasury bonds has risen by 20 basis points to 2.7% in the past five weeks. None of this is startling, but it does suggest that Americans' belief in price stability is not as firmly anchored as the central bankers might wish.
And the pressure is likely to increase. Energy prices have been rising sharply. Last year's spike in fuel prices had little effect on core consumer prices, but things are different now. America's labour markets are tighter and its firms operating more intensively. The capacity-utilisation index, a measure of firms' slack, stands at 81.3%, the tightest since 2000. The unemployment rate is at 4.7% and average hourly earnings rose by 3.8% in the year to April, up from 2.7% a year earlier.
The sanguine point out that, because profits are fat, firms need not pass higher costs on to prices. But it seems they are already doing so. Economists at JPMorgan note that companies have raised prices, as measured by the non-farm business deflator, by 3.1% in the past year, two percentage points faster than in 2003. The impact on overall core inflation has been muted, they argue, by imports of cheap consumer goods and by a temporary slowing of the prices of services, such as medical care.
Which leads to another big uncertainty in the months ahead. What impact, if any, will a falling dollar have on American inflation? After rising during 2005, the dollar seems to be heading resolutely south, in part because the interest-rate gaps between America and other countries are narrowing. Central bankers in Europe and Japan are promising tighter monetary policy even as the Fed may pause. At the same time rich-world governments are calling on China to let the yuan appreciate faster, with America to the fore. This week John Snow, the treasury secretary, said he was extremely dissatisfied with the slow and disappointing pacebut his department refrained from accusing China of manipulating the yuan in its semi-annual report on currencies.
On a trade-weighted basis the dollar has fallen by 3.6% since the start of the year (see chart). Given the size of America's external deficit, a further drop is likely. Less obvious is what effect this will have on inflation. In theory a falling currency implies higher import prices as foreign producers pass its effects on to their customers. But these links are much weaker than they used to be. A recent study by Fed economists found that in the late 1970s and 1980s a 10% currency depreciation would have increased import prices in G7 countries by nearly 7%. Over the past 15 years the rise would have been only 4%, and 3% in America. The impact on inflation, the study concluded, was negligible.
That suggests inflation hawks have little to fear from a gradual dollar slide. But not everyone agrees. Richard Berner, of Morgan Stanley, suggests that the pace of depreciation matters. He points out that the dollar seems to be falling faster this year than it did between 2002 and 2004 and argues that another 10% drop in its trade-weighted value could push core inflation to 2.5%. How far and fast the dollar falls will depend in part on how financial markets view Mr Bernanke's concerns about inflation. The more sanguine they think the Fed is, the faster the likely slide.
With its most recent statement, the Fed has given itself some room for manoeuvre. But the chances are that dollar bears and inflation hawks will conspire to push interest rates up.
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