"Current U.S. Federal Reserve Policy Could Accelerate Inflation"

n the past two years, the U.S. Federal Reserve has taken an increasingly backseat approach in tightening monetary policy to confront steadily rising U.S. inflation. Focusing more on sustaining economic growth than containing accelerating inflation, the Fed appears to be on the verge of abandoning its two year-long tightening cycle. Seemingly unbeknownst to investors, the Fed also appears to have discarded its decades-long policy of preempting inflation. The Fed's new dovish place in the trunk could greatly accelerate inflation in the second half of 2006, prompting dollar depreciation and a sharp increase in U.S. bond yields.

Fed Takes a Backseat Approach

The gradualist approach used by the Federal Reserve to tightening monetary policy during the past two years has done little or nothing to slow economic growth to a non-inflationary rate. Fear of dampening the housing market boom and personal consumption expenditure growth persuaded the Greenspan Fed to slowly push interest rates higher in barely noticeable 25 basis point increments. Accordingly, real estate prices soared and personal spending accelerated, pushing real G.D.P. growth to nearly four percent in 2004. Real G.D.P. growth accelerated further in the first three quarters of 2005, then abruptly slowed after devastating hurricanes struck the United States in the final quarter of the year.

With U.S. economic growth firmly above three percent for more than two years, a rate generally regarded to be non-inflationary, it is no surprise that inflation began to rise. Overly strong economic growth in the United States, the world's largest economy, sharply accelerated economic growth in many countries providing goods to U.S. consumers. The resultant jump in global economic growth produced a jump in global energy demand, gobbling up world energy supplies and pushing energy prices ever higher.

Initially, inflation was discernable only in surging energy prices. Producer prices in the United States also began to gallop higher, reaching 4.3 percent in 2004 and 5.5 percent in 2005. Despite accelerating producer price inflation, the Greenspan Fed and most analysts reasoned that producers had almost no pricing power, therefore very limited ability to pass on rising prices to consumers. Nonetheless, consumer price inflation edged higher, reaching 3.3 percent in 2004 and 3.4 percent in 2005.

Real G.D.P. growth re-accelerated in the first quarter of 2006, reaching an astonishing annualized rate of 5.6 percent. Economic growth also accelerated in most countries with strong trade ties to the United States, reigniting global energy demand and pushing energy prices higher. Surprisingly, U.S. inflation, by most measures, accelerated. Consumer price inflation reached an annualized rate of 4.3 percent and core consumer prices advanced by 2.6 percent, respectively, in the first half of 2006.

Even the Fed's treasured inflation yardstick, the core personal consumption expenditure (P.C.E.) deflator, jumped to a 12-year high of 2.9 percent in the second quarter of 2006 from 2.1 percent in the first quarter. Other U.S. inflation indicators such as wages and prices paid by manufacturers and service companies have also accelerated in the first half of 2006. Against the background of clearly accelerating inflation, the Fed's new chairman, Ben Bernanke, appears to have turned U.S. monetary policy in an even more accommodative direction.

On June 29, at the end of the last meeting of the Federal Open Market Committee (F.O.M.C.) of the U.S. Federal Reserve, the Board of Governors issued its usual statement describing factors influencing policy decisions. In a highly unusual move, the statement indicated that the Fed would base future policy changes on incoming economic data, encouraging the notion that an end to the current cycle of monetary policy tightening was near. Led by the U.S. stock market, global asset markets responded with a powerful rally.

Apparently, very few understood that the Fed had made a fundamental change in its approach to setting monetary policy. Since the years of the Volker Fed in the late 1970s and 1980s, U.S. monetary policy has been based on preempting inflation. In other words, monetary policy was designed to slow U.S. economic growth before inflation began to accelerate. This policy of preempting inflation was key to maintaining price stability in the United States during the past 20 years. Explicit in the Fed's last statement was a change in policy from preempting inflation to waiting until inflation accelerated further to act.

To justify this significant change in policy, the Fed statement pointed toward the lagging economic impact of past rate hikes and rising energy prices as factors that would slow the U.S. economy, doing the Fed's work for it. For this reason, U.S. and global asset markets rallied strongly again after second quarter U.S. economic growth data was released in late July, showing real G.D.P. growth unexpectedly decelerated to 2.5 percent. The same release showed that inflation accelerated sharply, which is not surprising considering that annualized real G.D.P. growth in the first half of 2006 was 4.1 percent despite the deceleration in the second quarter.

More indications of U.S. economic weakness in early August have convinced investors that interest rates have peaked. Remarkably, accelerating U.S. inflation does not appear to be undermining this conviction. Last Friday, unexpectedly weak U.S. employment data prompted many analysts, and at least one bond market guru, to predict that the Fed will not nudge interest rates higher at its upcoming meeting set for August 8. Fed fund futures showed that the chance of a rate hike on August 8 was only 16 percent, down from over 40 percent before the employment data was released. The same employment report showed an unexpectedly large rise in wages -- further indication that inflation is rising.

Conclusion

Regardless of whether the Federal Reserve stands pat, as advertised, or hikes interest rates by another 25 basis points on August 8, inflation in the United States will possibly head much higher in the months ahead -- even though U.S. economic growth will almost certainly slow as well. The seeds of higher inflation were sown by the Greenspan Fed during the past two years and fertilized heavily by the Bernanke Fed this year. These seeds sprouted overly strong global energy demand pitched against increasingly elusive energy supplies.

Because global geopolitical instability is hampering an increase in global energy supplies, the only way global energy demand and supply can become rebalanced is by a reduction in demand. Global energy demand growth will probably only contract if the U.S. economy -- and global economy -- falls into recession. Fed officials and investors have seemingly forgotten the lessons of the late 1970s, when accelerating inflation was only subdued after the Volker Fed pushed interest rates to stratospheric levels.

The economic stakes of policy errors by the Federal Reserve are much higher now than they were in the 1970s. Back then, foreign investors played almost no role in the U.S. bond market. Now, foreign investors hold more than 50 percent of all U.S. Treasury notes and bonds outstanding. If U.S. inflation accelerates sharply in the months ahead and the U.S. Federal Reserve remains well behind the inflation curve, real interest rates on Treasury notes and bonds could plummet, prompting significant dollar depreciation.

Dollar depreciation could snowball out of control if foreign investors begin to liquidate their increasingly underwater investments, pushing bond yields sharply higher. The bad news is higher bond yields will probably trigger a U.S. recession. The good news is global oil demand and supply will become rebalanced, pushing inflation lower.

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