Vital Signs: War of Words on Fed Policy, Inflation

On deck: speeches by Bernanke and Kohn, retail sales, business inventories, Empire State and Philly Fed Surveys, producer and consumer prices, industrial production, homebuilders survey, housing starts

By James C. Cooper

With all the monetary fuel sloshing around in the economy, investors have every right to be concerned about future inflation—and some Federal Reserve policymakers share their worries. After all, excess reserves in the banking system, which determine the economy’s money-creating potential, now stand at close $1 trillion, up from a comparatively trivial $2 billion or less prior to the financial crisis. Waiting too late to drain those funds from the system could unleash their potential to generate inflation.

The war of words among Federal Reserve policymakers over concerns about policy action and future inflation, which is already evident in the policymakers public speeches and comments recorded in past policy meetings, promises to heat up this week. Five Fed officials, including Chairman Ben Bernanke and Vice Chairman Don Kohn are scheduled to speak on the economy and policy. Remarks will also include those by two of the more hawkish regional Fed presidents, the Richmond Fed’s Jeffrey Lacker and the St. Louis Fed’s James Bullard. All this Fedspeak comes in a week when the Labor Dept. reports on October producer and consumer prices. The markets should get an earful.

The bottom line is that Bernanke and Kohn are the two most influential members of the policy committee, and they side with the doves. This group argues that the severe underutilization of resources in the economy, illustrated by October’s 10.2% jobless rate, will keep inflation pressures at bay for a long time, even as the economy picks up steam. The hawks are skeptical. They respond that popular measures of underutilized workers and facilities can misread the amount of slack in the economy, as happened in the 1970s when inflation and inflation expectations became unmoored.

For now, at least, economists see inflation over the next year or so as a non-issue. Through September, the policy-sensitive core rate of inflation, which strips away the ups and downs in energy and food to look at inflation’s underlying trend, is clearly heading down. Past experience shows that inflation keeps falling for at least a year after recessions end. That pattern should be reinforced this time by very weak labor markets, which are pushing down wage growth. Businesses are unlikely to face any significant cost pressures for a long time, given that the unemployment rate is expected to retreat only slowly. Indeed, so far this year, labor costs per unit of output, which are wages and benefits adjusted for productivity, have fallen at a record 5.4% annual rate.

However, the hawks are not so much concerned about inflation in the next year but about price stability in the future, especially amid current Congressional challenges to the Fed’s independence and the ballooning federal deficit. One of their worries is that an extended period of easy money could fuel expectations of inflation, which can perpetuate higher inflation and are difficult to reverse once they are engrained in business and consumer behavior.

Investors are sure to get a full airing of the arguments on both sides of the policy table this week, as the Fed continues to plot its exit strategy from its massive monetary accommodation of the past year.

Here’s the weekly calendar, from Action Economics.

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