Tuesday, February 26, 2008

Is the Fed in Denial About Inflation?

Home prices are falling, but consumer and producer prices are rising. That’s a conundrum for the Fed.

Do investors really want the central bank to keep easing interest rates in the teeth of a 4.3 percent 12-month change in the consumer price index?

Or in the teeth of a 7.7 percent rise in the producer price index?

While I’ve been a bit dovish on inflation, data over the last 3 or 4 months are changing my mind. Inflation first peaked in July 2005, and then gradually declined through the end of 2006. But since the summer of 2007 — and especially in recent months — there has been an alarming rise of inflation.

Economist Brian Wesbury says the Fed is in denial about rising prices. I think he’s right.

Here’s another problem. The Fed is going to be easing interest rates in the teeth of $950 gold and $101 oil! This can’t make any sense to the average Main Street Joe out there.

At the end of the day, the job of the Fed is to stabilize the level of prices, or at least to keep the increase in the price level to less than 2 percent. But the yearly changes are way, way above 2 percent.

And using the so-called core inflation rate (which excludes food and energy) simply makes no sense over longer periods of time. In other words, core prices from month to month, and quarter to quarter, may be useful guides for the Fed, but they are no longer useful over periods of 12 months or longer. The rise of inflation, measured as a 12-month change, is truly significant over the past 4 months. It’s a problem.

The Fed should stop easing right now, and it should maintain that posture until commodity prices start falling.

Incidentally, one of the reasons why voters are so negative on the economy is the increase in the price of energy, gasoline, oil, home heating fuels, and food. Surely the Fed — which is in charge of inflation (since it is a monetary problem) — should resist adding fuel to this flame.

But here’s another problem. Since Hill-Bama didn’t appoint Ben Bernanke, and Bush did, they can criticize the inflation problem. Meanwhile, Republicans may wind up getting blamed for it. Sen. McCain needs to develop a plan to address it.

In short, this inflation story is becoming a real big problem, in political and economic terms.