Friday, July 21, 2006

More on Bernanke

Bernanke was a lot tougher in yesterday’s House Financial Services hearing. He was much more hawkish. In response to a question posed to him, he replied that the core inflation pickup is broad based, and not a statistical illusion from the owners’ equivalent rent component of the CPI.

Gold prices fell almost $10 dollars, nearly erasing Wednesday’s gain (which in some sense was based on a dovish misreading of Bernanke.) If the Fed is data dependent, and if Bernanke believes that the core inflation pickup is broad based, then more fed rate hikes are in the cards.

Reuven Brenner’s article on National Review Online (“What’s Wrong with Fed Policy”) makes the important point that the Fed should be using a liquidity management model based on commodities including gold, the yield curve and the dollar exchange rate to guide policy, rather than an interest rate and unemployment rate management approach.

My reading of the Fed is that they’re essentially using both. They will continue to target the Fed funds rate with one eye on the TIPS bond market yield model, with perhaps a glance at commodities and the dollar, but their other eye is unfortunately still trained on the Phillips Curve tradeoff between inflation and unemployment, with various references to capacity utilization, output gaps and other economic growth speed limits. This stuff is what gets the Fed into trouble because inflation is a monetary phenomenon.

Think of it this way, over the past ten years, non-financial productivity has grown at a 3.5 percent annual rate with labor force growth at least 1 percent annually. That means the economy’s potential to grow is actually about 4.5 percent per year. With continued low tax rates on investment, plus a capital goods investment recovery cycle in hand, the idea of economic capacity constraints makes no sense at all.

The reason the dollar is weak is because there is still a modest excess dollar liquidity position in relation to demand. I still don’t think it’s a huge excess, but I’d like to see a stronger dollar and a narrower TIPS spread.

All that said, the Fed will get there in the months ahead.