Last week, I promised to talk more about the Federal Reserve and inflation, so here goes.

Current Fed policy accepts strong historical evidence that a financial crisis, such as we experienced in 2007 and 2008, sucks money and confidence out of the economy, resulting in nasty consequences that can persist for years. Therefore, in an attempt to avoid a complete collapse of the financial system, the Fed took several extraordinary steps. First, they became the lender of last resort. Next, they replaced some of the money the crisis destroyed. Lastly, they kept U.S. Treasury interest rates low enough to push investors into riskier assets, such as equities, which can help increase equity prices.  Higher equity prices translate to greater household wealth, which have resulted in greater consumption and, ultimately, increased investment and hiring.

Fed officials contend that higher food and energy prices don’t justify tightening their current expansionary policy because “core” inflation remains weak and inflationary expectations remain low.  On the core vs. headline inflation issue, as I’ve written before,  “Sure Fed officials eat and drive, but because commodity price rises tend to depress both consumption and profits, they also tend to slow economic growth and thwart demands for higher wages and prices.”

The latter issue—higher inflation expectations—is more important because once employees anticipate higher prices, they will demand higher wages. In turn, businesses that believe they can raise prices will more readily agree to increased wages. As a result, inflation spirals upward.  Today, market indicators and survey results show inflationary expectations are rising. Inflation rising to the point of dispelling fears of deflation is fine, but rising enough to recreate the inflation of the 1970s isn’t.  Therefore, at some point, Fed policy must tighten. But will the Fed act if high unemployment persists?  That’s where I get worried, because that’s where politics enters the equation. 

Read Fed Chairman Arthur Burns’s speech, “The Anguish of Central Banking.” Throughout the Great Inflation of the 1970s, Fed officials understood that a very tight monetary policy could crush inflation, but also believed that the body politic would not tolerate the deep recession that would follow; therefore, they failed to act decisively.  A few years later, Fed Chairman Paul Volker proved to be made of sterner stuff. 

Will Chairman Bernanke or his successor face a similar choice?  Don’t look at the price of oil for an indication;  rather, monitor expectations for inflation to gauge his or her response.

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