The Fed’s attempt to assuage inflation fears that don’t need assuaging

by Rebecca

There is no shortage of speeches by US central bankers these days. The following is an excerpt from a NY Times article that highlights the debate among key Fed officials about the speed and method of stimulus withdrawal once the decision to exit has been made:

Mr. Bernanke and other officials want to see evidence that the economic recovery is self-sustaining, strong enough to generate jobs without the crutch of extremely low interest rates.

But Mr. Warsh, as a Fed governor, has begun arguing that the central bank cannot afford to wait for irrefutable evidence of a solid expansion. Mr. Warsh recently argued that the Fed should take at least some of its cue from stock prices and other financial indicators, which turn around earlier and more quickly than the underlying economy.
…
Mr. Warsh and some other Fed officials also argue that when the time does come to change gears, the central bank may have to raise rates almost as fast as it slashed them when the crisis began.

We are far from seeing “irrefutable evidence of a solid expansion”. This debate is likely confusing the public more than anything else, or as my title puts it: the Fed is attempting to assuage inflation fears that don’t need assuaging. There is simply no measured inflation concern at this time, not even over the next ten years.

The chart illustrates the 30-day moving average of expected inflation for the next 5, 7, 10, and 20 years. Expected inflation, roughly speaking, is the nominal Treasury Security rate minus the associated Treasury Inflation-Protected Security (TIPS) rate, the real rate of return or the break-even rate. Technically this break-even rate is not a perfect measure of inflation expectations; but it’s close and measured daily (see this SF Fed article for more on TIPS).

The “inflation problem” is way overstated in the media. Roughly speaking, markets have priced in just 1.3% annual inflation each year over the next five years, 2% over the next ten years.

By giving speech after speech (Bernanke’s latest), the Fed is attempting to keep inflation expectations in check. However, the Fed is walking a fine line between alleviating concerns about long-term inflation prospects and overemphasizing the short-term disinflation (deflation) risks.

Rebecca Wilder