"The first votes are in
The Federal Reserve can't be entirely pleased with markets' reaction to its announcement on Wednesday of quantitative goals for purchases of long-term assets.
The Fed's objective in this quantitative easing is to move the inflation rate back into positive territory. Let's begin by reviewing the new consumer price index data that were also released on Wednesday by the Bureau of Labor Statistics. These numbers show further modest movement away from a deflationary tendency prior to any actions by the Fed. The seasonally adjusted February CPI was 0.4% higher than in January, which would be a 4.8% annual inflation rate if sustained for a year. Although that's plenty for one month, it nevertheless is still substantially smaller in absolute value than the drops seen in October through December.
That leaves the seasonally unadjusted CPI just 0.2% above its value from February 2008.
If we leave out food and energy, the February increase (+0.2% monthly) implies an annual inflation rate of 2.4%,
and the year-over-year core inflation rate now stands at 1.8%. Both of these last two numbers are a bit below what I think the Fed should want to see, but they continue to offer comfort that we had been moving away from the deflation threat before the Fed's announcement.
In discussing the Fed's announcement of its plan for quantitative easing, I wrote:
What will be the indication that we've done all we can with this tool? I would urge the Fed to be watching the exchange rate and commodity prices quite closely for an indication that the deflation tide has turned.
That's why I doubt the Fed was pleased to see the dollar fall 5% against the euro last week. The Fed wanted everybody to wake up and notice that deflation is no longer on the table, but it's another thing if markets run off in the other direction fearful that a major inflation is coming. Notwithstanding, the dollar's move at the end of the week only served to undo an appreciation over the first part of the year, an appreciation that may have been unwelcome and unwarranted.
Prices of a number of commodities also zipped up about 5% on the news. Again this is a disturbing development, but again it still leaves the prices of many commodities below where they started the year, as the graph below demonstrates.
Commodity prices are quite sensitive to the level of real economic activity. If we had been about to repeat a global Great Depression with attendant significant U.S. deflation, maybe $35 oil could be justified. And if the Fed has now successfully communicated that's not going to happen, a commodities rebound might be quite appropriate.
But I think we also have to worry about whether this might be the start of a replay of what we saw a year ago, when excessively expansionary Fed policy provided fuel for commodity price speculation. In January of this year, Fed Chair Ben Bernanke offered this ex post appraisal of the Fed's policy in early 2008:
The [FOMC's] aggressive monetary easing was not without risks. During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities. The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations. However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices--as reflected, for example, in the pattern of futures market prices. As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.
Bernanke seemed here to be taking the position that since the Fed got the long run correct-- the end of 2008 brought strong disinflationary pressures and commodity prices collapsed-- it was OK to ignore the commodity price boom of early 2008. I disagree with that assessment. In my opinion, the oil price increase of 2008:H1 was highly destabilizing for the economy and a key factor that turned an economic slowdown into a recession. One of the lessons for monetary policy that we should draw from the recent behavior of real estate and commodity prices is that the Fed can't ignore the consequences of its actions for speculative prices, even if (or perhaps, particularly if) that speculation reflects a basic misreading of fundamentals. If commodity speculators are erroneously about to declare the bull game is back, that in my mind would be a development that would require the Fed to scale back its plans for quantitative easing.
How would I handle that in practice? I think the best strategy is for the Fed to lay all its cards on the table face up, telling everybody exactly what it is hoping to achieve and how it is going to do it. The Fed needs to communicate that it's not going to allow the price level to fall, but it's also not going to allow runaway commodity prices. So why not announce a specific target of, say, 2-3% for headline inflation, which implies a direct commitment that the Fed will become more cautious if it observes a response to its actions of items such as oil and food? This could be accompanied by statements from Fed officials along the lines that they're watching commodity markets and exchange rates closely for an indication that quantitative easing has accomplished all it set out to do.
All this requires acknowledging from the outset that there is only so much the Fed can accomplish in this situation, a premise that in my mind has considerable merit. But in order to be able to contribute whatever it can, the Fed must be able to speak with clarity and credibility.
If the moves we saw in exchange rates and commodity prices this week are the end of the story, then I think all is well. But if they are the beginning of a new trend, the Fed will need to react."