Part of what is allowing the Federal Reserve to continue promising an endless period of low interest rates is the fact that – or at least they claim – we aren't yet experiencing any inflation here in the US. I get the logic: the big pitfall of keeping rates so low for so long is inflation but with an economy that is barely growing, we can ignore inflation for now (or even cry deflation) and continue the path to devaluing the dollar for greater short-term economic benefits. Perhaps the reason why Bernanke isn't so concerned is that if banks actually start deploying capital at some point the Fed should be able to drain liquidity fast enough to cut inflation before it became a serious problem. However, whether or not the Fed can actually do that is a much bigger question mark than some people realize.
I might first point out that the Fed seems to be totally disconnected from what the actual level of inflation is. The Fed focuses on the PCE (personal consumption expenditures index) for inflation. They use this measure over the CPI because the PCE assumes substitution – basically that you'll switch from filet mignon to chicken nuggets if the prices get too high. However they ultimately arrive at these inflation figures, most non-academics seem to think they are manipulated. Prices on things middle class consumers purchase have been rising by 5-7% per year, perhaps more on commodities like food and energy which the Fed also conveniently excludes from their statistics.
While it is nearly impossible to argue that we aren't experiencing inflation in service prices, food prices, or fuel prices, what keeps inflation stats contained to some extent is the crippled housing market. Unwinding this huge bubble fueled by excessive debt keeps the inflation readings low because this massive sector of our economy is still down and out. However, most people don't feel the downward pressure on inflation caused by the housing market because the average person stays in their home for years at a time. The rising price of filling up a gas tank or a rising health-care premium matters much more to the average person than a tick up or down in a home's appraised value.
In an article from the Journal of Indexes, Harvard professor George Bates also notes that a sudden revaluation of Chinese currency could breed inflation rather quickly. As the largest importer of Chinese goods, the US would become a big beneficiary of that inflation in a hurry.
Perhaps this morning's (2/3/11) upbeat jobs data and stock market rally will cause the Fed to push up interest rates well before the 2014 target they have set. Once economic growth seems to be on a sustainable path, the Fed should quit messing with the market and embrace a strong dollar and rising rates. These are signs of economic recovery!
As always, feel free to e-mail me with any questions or concerns.
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