Wednesday, April 23, 2008

The Creeping Problem of Inflation

From the

Inflation concerns . . . are again on the rise. On Tuesday, the dollar hit an all-time low of $1.5991 against the euro, and crude oil closed at an all-time high of $119.37 a barrel.

The story provides a good run-down of what current price instability (especially the prices of food and energy) might mean for our present economic situation.

Simply put, inflation is a problem for growth. Inflation's creeping existence -- or just the threat of its creeping existence -- might prevent the Federal Reserve from doing what it would have to do to foster growth. Pumping more money into the economy, or cutting interest rates lower, actions meant to help trigger growth, could instead trigger massive inflationary pressure. This inflation could then combine with the contraction of the economy to create the 1970's phenomenon, 'stagflation.'

No wonder that, as the article mentions, members of the Fed are voicing increased fear of what inflation might do to our already troubled economy.

For example, at the March 18 Federal Open Market Committee (FOMC -- minutes) two members of the committee dissented from the 75 point interest rate cut that was ultimately put in motion. The explanation of the dissent gives us some insight into the tricky balancing act of growth and inflation now challenging our nation's leading economists. So let's look at the dissent, taken straight from the minutes of the meeting.

Messrs. Fisher and Plosser dissented because, in light of heightened inflation risks, they favored easing policy less aggressively. Incoming data suggested a weaker near-term outlook for economic growth, but the Committee's earlier policy moves had already reduced the target federal funds rate by 225 basis points to address risks to growth, and the full effect of those rate cuts had yet to be felt. While financial markets remained under stress, the Federal Reserve had already taken separate, significant actions to address liquidity issues in markets. In fact, Mr. Fisher felt that focusing on measures targeted at relieving liquidity strains would improve economic prospects more quickly and lastingly than would further reductions in the federal funds rate at this point; he believed that alleviating these strains would increase the efficacy of the earlier rate cuts. Both Messrs. Fisher and Plosser were concerned that inflation expectations could potentially become unhinged should the Committee continue to lower the funds rate in the current environment. They pointed to measures of inflation and indicators of inflation expectations that had risen, and Mr. Fisher stressed the international influences on U.S. inflation rates. Mr. Plosser noted that the Committee could not afford to wait until there was clear evidence that inflation expectations were no longer anchored, as by then it would be too late to prevent a further increase in inflation pressures.

Stay tuned.

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