Federal Reserve is now playing a high-risk game with inflation

The US Federal Reserve is increasing its balance sheet by another $1 trillion, including $300bn of Treasury bonds, the Federal Open Market Committee said on Wednesday.

Yet the pace of US economic decline seems to be slowing, while deflation is nowhere visible. Fed policy is now high-risk, and resurgent inflation may strike sooner than expected.

The FOMC said it expects inflation to remain subdued with some risk it could “persist for a time below rates that best foster economic growth”. Notably, the Fed is not now forecasting actual deflation.

That’s not surprising, since February’s top-line consumer price index rose 0.4pc, equivalent to 4.8pc annually, while core consumer prices also rose, by 0.2pc. The Cleveland Fed’s median CPI was 2.8pc above the previous year. February’s producer price inflation was marginally lower, with the headline index rising at 1.2pc annually and the core measure at 2.4pc.

Meanwhile, last week’s unexpectedly strong February retail sales and Institute for Supply Management index readings suggest that economic decline is slowing.

The experience of the 1970s in both the United States and Britain demonstrates that the Fed’s theory that inflation won’t co-exist with economic slack is wrong. Thus an over-inflationary monetary or fiscal policy could quickly produce accelerating inflation even while recession persists.

The Fed’s proposed purchase of $300bn of long-term Treasury bonds, when combined with the Obama administration’s record budget deficits, is particularly risky. Running large budget deficits and monetising them through central bank purchases of debt is a highly inflationary policy that has got plenty of emerging markets into trouble.

Related article: Fed to Buy $300 Billion of Longer-Term Treasuries (Bloomberg)

Broad money growth, whether by the M2 metric or by the St. Louis Fed’s MZM figure, has been running at over 15pc annually since last September. The $1trillion further expansion of the Fed’s balance sheet is very likely to accelerate this. The effect may not be obvious in the short term. But at some point, it is almost inevitable inflation will return, probably with force.

The Fed will then need to reverse policy with the speed and verve of a racing driver. Unfortunately, the odds are against it doing so before inflation has taken hold.

By Martin Hutchinson, breakingviews.com
Last Updated: 8:55AM GMT 19 Mar 2009

Source: The Telegraph

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