Tim Duy: Fed Has Head in the Sand on Inflation and the Dollar

Tim Duy, posting at Economist’s View, is disturbed that the Fed isn’t giving much weight to rising inflation in its monetary calculus. Duy, a Fedwatcher, more than once underestimated the central bank’s interest rate cuts because it was inconceivable to him that anyone who read the data could think that repeated aggressive cuts were warranted.

Heretofore, Duy has maintained a detached tone. But the Fed choosing to ignore clear signs of rising inflation expectations and acting as if it does not understand that trashing the dollar is a major culprit is troubling. And how could consumers miss these price increases? Gas and food, the items they buy most frequently, have been on a relentless march upwards. The logic of excluding them from the consumer price index is that they are volatile, but as Barry Ritholtz noted, that’s not accurate. They have been unidirectional.

Duy isn’t the first normally-dispassionate economist to become upset by the central bank’s. conduct. Jim Hamilton has also gotten unusually pointed.

Duy mentions that a “weak job market” may serve to temper inflation, which would result because a lack of jobs meanrs workers cannot demand more pay to compensate for higher prices. But labor has had no bargaining power for years even in an era of low nominal employment. Bernanke and his cohort are no doubt betting that employees’ ability to extract more pay is not getting stronger any time soon.
From Duy:

It is simply delusional to deny the impact of surging inflation on household spending. The April reading on consumer confidence pegs year-ahead inflation expectations at 4.8%, up from 3.4% just three months earlier in January and the highest since 1990. This is not good….. If the Fed continues to pursue policy that confirms agents near term inflation expectations, longer term expectations will rise accordingly. That would leave the weak job market as the last defense against a fundamental shift in the inflation regime. Let’s hope it won’t come to that.

Of course, the Fed sees inflation – it is all over the most recent minutes:

Real disposable personal income was unchanged in the fourth quarter, held down by higher food and energy prices, and moved up only slightly in January…

Household survey measures of expectations for year-ahead inflation jumped in March to their highest levels in about two years; in contrast, survey measures of longer-term inflation expectations were unchanged or up slightly…

Payroll employment declined substantially; oil prices surged again, crimping real household incomes; and measures of consumer and business sentiment deteriorated sharply.

Honestly, it is tough to justify the Fed’s continue description of inflation as merely “elevated” given their own descriptions of inflation in the minutes. And note the Fed remains hesitant to recognize its role in fostering higher inflation. They come close on at least one front:

Agricultural prices were rising at a substantial clip, partly in response to strong global demand, lean supplies, and a lower foreign exchange value of the dollar… the recent depreciation of the dollar could boost import prices and thus contribute to higher inflation.

They accept the inflationary consequences of a weaker Dollar, including the link to agricultural prices (and, presumably, energy prices). They then take comfort in the “anticipated … flattening of oil and other commodity prices,” seeming to ignore that their policy stance has something to do with the Dollar. Still, one cannot imagine that they do recognize this link. If so, they leave a pretty clear trail of breadcrumbs between their policy and recent “elevated” inflation rates – a clear enough trail that one would think they would be more cautious about pace of easing (or additional easing at all).

Interestingly, the sagging Dollar clearly elicited a stronger response from the G7 in this weekend’s communiqué, giving hope that the Fed is becoming more aware of the full implications of their policy stance:

Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability.

Presumably, both Fed Chairman Ben Bernanake and US Treasury Secretary Henry Paulson signed off on this language. So it is reasonable to conclude that the Fed is starting to get just a bit more concerned that their policy choices are having some unintended consequences. Of course, if the G7 was really concerned about exchange rate stability, they would put more effort into coordinating monetary policy than jawboning currency traders. Instead, G7 policymakers must realize the current state of affairs will continue (it is their decision, after all), particularly the policy gulf between the Fed and the ECB. Which means they expect ongoing pressure on Dollar, enough pressure to elicit stronger jawboning from the G7.

I anticipate jawboning will have its expected impact, at least initially, including a hit to commodities. When the novelty wears off, will the G7 resort to the more forceful tool of coordinated intervention? I honestly hope this does not devolve into an episode of the Fed easing policy on one hand and then intervening to support the Dollar with the other hand. I find those situations to be emotionally draining – like watching a friend in a self destructive pattern but being unable to help.

I fully appreciate the current policy dilemma Bernanke & Co. face – this is not your garden variety Keynesian slowdown. The yawning current account deficit represents consumption in excess of productive capabilities, and we are resolving that imbalance. The resolution entails accepting some moderation of domestic demand in concert with expansion of external demand that will be consistent with a new constellation of interest rates, exchange rates, and prices. It is not obvious, a priori, that we know the monetary policy consistent with that new equilibrium. But policymakers should realize that implications of that adjustment when setting policy.

My concern remains that the Fed has panicked in setting a rate policy that treats the external sector – and therefore, the current account adjustment – as a mere curiosity, giving little thought to their role in supporting the adjustment. In effect, policy, both monetary and fiscal, has degraded into an effort to dig the economy out of a hole by shoveling deeper. We built the most recent expansion on the back of debt financing, driving consumption gains while real median incomes stagnated on the theory that you can borrow your way to prosperity. That theory has proven ill-advised at best; the inability to continuously fuel the borrowing binge through housing provided the initial blow to the consumer. The second blow was the softening job market due to the first blow. The third blow was the inflation driven by the policy response designed to minimize the impact of the first two blows. The question now is: does the Fed read the increased pain of consumers as a reason to cut rates 50bp at the next outing of the FOMC? I hope not – but I cannot rule it out.

Then again – perhaps we are simply at the point where inflation is the only politically palatable option. The Bear Sterns rescue is the basis for a massive, fully monetized bailout of the financial sector…and Congress and the next President would oblige. If that is where we are headed, somebody needs to start thinking about capital controls before the rest of the world realizes the US intends to repay its obligations with very devalued Dollars.

Bottom Line: As has been the case for months, I would be much less concerned about the path of monetary policy in the absence of rapidly increasing commodity prices and a declining Dollar. I do not believe it is advisable to let the Dollar completely disintegrate. And given the increasingly clear link between monetary policy, the Dollar, and commodity prices, the Fed would be best to served to moderate the pace of easing. I think they understand this, but I remain worried that fundamentally, they only have one tool, and they will feel a need to keep using it if only to look like they are doing something. This is especially worrisome given that low interest rates are apparently not providing much of a fix for Wall Street – for that, the Fed needs to focus on reducing counterparty risk.

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  1. Anonymous

    Heads are in the sand everywhere these days!

    In for a penny
    Apr 13th 2008
    From Economist.com

    The illusory strength of the British pound


    The Bank of England has also been caught in the middle. It has neither been as decisive as the Federal Reserve, with its frequent rate cuts, nor as stern in its anti-inflationary rhetoric as the European Central Bank. The three rate cuts it has delivered so far do not look sufficient to revive the housing market but they may have been enough to make investors worry about its determination to tackle price pressures.

    Indeed, Mansoor Mohi-uddin, a currency strategist at UBS, says the Bank of England may be playing a dangerous game by appearing to welcome the currency’s weakness. “Currencies can overshoot their fundamental fair values far more sharply if confidence in domestic policymaking fails,” he says. The pound could even lose its relative strength against the dollar; few think the recent range of $1.90-2.05 is its most appropriate level.

  2. Anonymous

    Tim I have news for you the FED doesn’t give a rats rump about the dollar which by the way now that you just noticed that little darling has been falling since 2003.

  3. Doug

    Tim Duy looks to the joint communique as an indication of awareness about inflation, etc. He writes:

    “Presumably, both Fed Chairman Ben Bernanake and US Treasury Secretary Henry Paulson signed off on this language. So it is reasonable to conclude that the Fed is starting to get just a bit more concerned that their policy choices are having some unintended consequences.”

    There is a subtle but critical point to be made here that Duy fails to understand. We no longer live in a world where an official’s word can be so interpreted. In the old days, some sense of contract/social contract prevailed. Not always, of course. But it would have been reasonable for Duy to interpret the signing of this language as indication of future behavior.

    No more. When Bernanke, and especially Paulson, sign this all they have done is sign this. There is no greater import than that. We no longer live in a world where the expectations of ‘contract’ prevail. Instead, we live in an ‘options’ world. Each moment is a separate transaction. All that is indicated is a preservation of position and options. All words and actions are but contingencies.

    This is the prevailing belief and behavior system. And, culturally, it helps clarify just how difficult it will ever be to remedy the significant counterparty concerns now bedeviling so many paths forward.

  4. Independent Accountant

    You got it. No official pronouncement should be taken at face value. No official statistic accepted either. The Fed’s policy is: inflate to protect the banks. Monetize everything in sight if need be to protect them. Or do you believe Helicopter Ben (1590 SATs) is so stupid he doesn’t know what he is doing?

  5. jm

    But the dollar has to fall. It’s hugely overvalued. The longer it stays hugely overvalued, the greater the cumulative distortions in the economic system.

    The fact that prices for food and fuel are rising while wages are not is in fact strong evidence that the rises are not due to inflation.

    Inflation is not rising prices, it’s prices rising because the money supply is increasing more rapidly than the supply of goods and services.

    Prices rising because of increasing competition from other consumers for commodities in limited supply is not inflation.

    The pain to the average American is being intensified because an adjustment in exchange rates that should have taken place gradually was delayed and is now sharper and more sudden than it might have been, and — more importantly — that exactly because Asian nations continue to mercantilistically peg their currencies to the dollar at unnaturally low rates, all the adjustment must take place against the unpegged currencies, further distorting the system — in particular, by preventing American workers from competing on even terms with those of Asia.

  6. Richard Kline

    We don’t face either asset price deflation, (currency depreciation and so import cost) inflation, or commodity supply constraints: we face all of them. The unilateral, power-dive, rate reductions we have seen in the US without co-ordination with the ECB or East Asia have been unwise, although they have had the effect of mitigating the ARM reset chokehold on failing mortgages if at great cost. Given that a) we already have negative real interest rates in the US, and b) further cuts will not aid financial institutions because they are insolvent and have nothing to lend, further near-term and unilateral cuts in the FedFunds would be useless, costly, and dangerous. Will the Fed cut? Of course: people do what they know . . . .

    The rest of the world already knows that they are going to be paid off in shunken dollars, Tim. Whether that happens because we walk down the stairs, fall down the stairs, or get kicked down the stairs to so doesn’t matter all that much _to the rest of the world_. If they are remotely smart, they aren’t waiting on G7 boilerplate but are already pricing in their repositioning strategies. The only players who don’t seem to have a repositioning strategy are the UK and the US; they’re still using the same old requisitioning strategy. *sigh*

  7. sk

    His casual reference to capital (export) controls astonishes me – its all so dry and apparatchik isn’t it ? I reluctantly accept that the US$ in my pocket is elastic, dancing to the tune of the Fed but now I have to worry about whether my pocket ( and the US$ in it ) can move out of the country or not ?

    Of course I expect the clamor for this stuff to increase and I will just increase my efforts to evade their efforts – because I have to. Should I just sit there and lose money ?

    Isn’t it truly awful and downright immoral that people follow their wrong policies to the bitter end ?

  8. Keith

    Ever consider this might be intentional?

    5% inflation for 5 years will prop up the housing prices and get us back on track after the housing bubble faster than any other solution.

    It’ll also keep us out of Japan’s lost decade.

    At the cost of everyone’s assets being devalued by 30+%. We’re socializing the losses a different way.

  9. Anonymous

    JM is correct that much of the current price increases are not due to inflation. The problem is, when do any future rate cuts (and yes, come they will) begin to be inflationary?

    The availability of cheap money will continue to retard (but not prevent) any future corrections.

  10. Anonymous

    The discussion seems to forget the role of banks in a fractional reserve system. Given constant risk aversion and constant bank assets, increased lending by the Fed to banks would increase the money supply markedly. However, bank assets have declined and they’ve cut back on lending. It’s not clear what wins in terms of the available money supply–the Feds actions to increase money available or the banks’ shrinkage in lending. Any ideas on which force wins out?

  11. doc holiday


    5% inflation for 3 years and a decrease in home values of another 15% should hit the nail on the head! Great point! The main issue three years out will be the impact on savings accounts and jobs which will bring buying back into vogue, so more than likely we see 2 years of forced “positive inflation” which ben has said he is in favor of, then a faster decline of home values. The thinking seems to be get the exorcism over with as fast as possible and get the garden growing as soon as possible, so this will seem more like stagflation IMHO and may take 2 years of intense pain, i.e, cash will be king in a liquidity trap and then out of the bottom will come slow growth

  12. Lord

    A falling dollar is not the problem but the cure. Yes this leads to higher prices, especially in oil and food which will add to costs, but we are closer to the end of interest rate reductions than the beginning and the dollar won’t fall much further and prices won’t rise much further. The Fed is accommodative, but it will take much accommodation for an extended period of time for the rest of economy to take up the slack from the financial crises. Exports and tourism will help along with reduced imports, but it will take time and other areas to help out.

  13. doc holiday

    I think Jackie is a harbinger for this recession:

    Berkshire Hathaway Inc. spokeswoman Jackie Wilson said Monday that there was no one available to discuss the leadership change at General Re..

    Re: Psychological mechanism


    The actual mechanism of harbingers appears to be a quirk of human psychology. There are two general categories of symbolic prescience, both of which are subject to an individual’s awareness of laws of probability. Whether one is cognizant of the direction events in their life are headed, the subconscious keeps account of what is likely to happen in one’s future. Depending on how aware a person is of these subtle instincts, their anticipation of imminent events will vary.
    An aware person will be able to explicitly imagine specific events, while someone who is less aware, or in denial, will not sense, or will ignore, the anticipatory signals their subconscious sends to prepare them in how they will respond to unfolding events.
    Someone who is less than fully aware, but more than blindly ignorant, may encounter some sort of symbolic image which embodies the course of events their subconscious is trying to make them anticipate. Such an encounter may enhance the person’s understanding, or in some other way make it easier for them to understand and accept the probability of unfolding events in their life. Subjectively, the person will have felt they had no previous intuition of events unfolding as the “sign” indicated. Should events then unfold accordingly, the person may be predisposed to believe in omens.

  14. S

    Can some please explain how 5% inflation a year for 5 years or whatever the time frame means anything if wages aren’t likewise inflating(note ECB members warning other countries to not use Germany as a benchmark – this while Japan implores companies to raise wages). This is like the knee jerk response that tariffs caused the great depression – which in fact had approximately 0 to do with it. Inflation (defined here as increase growth in money supply) does nothing to solve this problem other than let the banks recapitalize at depositor expense). if nominal interest rates are suppressed by exogenous forces and wages are capped as employment fear lends even more leverage to employers. Comment makes excellent point that we have it all which is hard to fathom but has been put nicely by the folks at Minyanville – Things we need vs. things we want. The argument over which will win is useful for obfuscating the situation, clearly beneficial to the Fed, but it ignores reality. There are structural and secular issues at work, none in favor of the United States mind you. The dollar has a geopolitical angle as well, which is to say the US driving the peggers into the ground with inflation and hence ending the mercantilist binge. Always a silver lining, minute as it is.

    It is interesting that Wachovia projecting net interest income up 5-7% in Q2 on back of deposit growth and likely some NIM expansion. The reflation of the banks is coming at the expense of the consumer. So no wage growth and no return expansion – zero impact to affordability ratios – means zero impact to consumers. Add on that incremental credit isn’t flowing to anyone and again consumer getting short end. BOE head today urging banks to pass on the mortgage cuts to consumers – probably populist jawboning but nevertheless interesting.

    I have seen this inflation argument in lots of places and excuse my ignorance but could someone please explain how inflation for five years does anything for the consumer (unless than banks are handing it out. That only serves to help Home depot’s wheelbarrow sales. It didn’t work for Germany, it hasn’t worked for Zimbabwe and will not work for USA. Explain please…or lets put this argument where it belongs for good: the ash heap.

    It is interesting that all these long term institutional investors are buying these bank issues – as the WSJ put bluntly long term loses purchasing power. This is a stretch but perhaps the feds could be leaning on the major asset mangers (Fidelity, Wellington tc) to take this equity/convert/debt down. Who will eat it, the 401K holders who have for all intensive purposes passive fixed equity asset allocations which will continue coming over time as they have been conditioned to believe that it is a “good” investment? This is a perfect annuity vehicle for the Feds to go after to bail out the system. It is long term capital (in theory) and it is captive and relatively benign. They have drained FHLB (see article on Chicago bank ratings downgrade per failed merger with Dallas), Fed Window, auctions, rebate programs etc.

    Sinister for sure.

  15. Max

    Keith said…
    Ever consider this might be intentional?

    5% inflation for 5 years will prop up the housing prices and get us back on track after the housing bubble faster than any other solution.

    I disagree, in that there is no way to know if the (intentional) weak dollar policy will work as intented. The most possible scenario that is playing out now (and why doesn’t anyone talk about it ?!) is that the USD becomes the carry-trade currency, replacing the yen.

    What’s the point investing in the oversupply of US real-estate, when there are far more attractive yields elsewhere (like exploring oil, and developing agriculture)? This will spell disaster for the Fed.

    The assumption that the policy of “inflating-away” our debt rests solely on an outdated view of the continuing dollar hegemony. It’s a dangerous view.

  16. Richard Kline

    To Keith on the potential for intentional inflation as a debt-run off strategy, you don’t want to give too much credit to policy makers in the US on ‘intentionality’ here. I mean that seriously, not facetiously.

    The problem with inflation as a strategy is that it has multiple outputs. Yes, the ‘value’ of fixed debts seems smaller, but as pointed out above either wages for the small debtor or profits for the big one have to also rise to make use of the presumed advantage. There is nothing to suggest that either will occur in the near term, and not much cause for optimism mid-term. Neg rates in Japan didn’t ‘melt off’ that mountain of congealed debt because economic ‘metabolic’ activity dropped to comatose levels. Then as Max mentions, if foreign capital dumps the dollar or simply walks away from it because it’s soft and shrinking, we get huge cost increases and downward pressure on actual capital. Inflation as a debt-write down only works if furriners are so stupid as to keep paying in money to be written down which we can use to pay off each other’s debts. Boy, is that NOT going to happen. Find me a country which has inflated it’s way out of trouble; most just change the nature of their problem without eliminating the existence of a problem.

    The point at which we will know that we have a grip on ending the long bad patch now starting is when we _raise_ rates to attract capital and firm up real profits in the credit markets. Only then will we find out what assets are really worth and what companies actually are capable of turning a real profit without floating along on cheap credit. I don’t necessarily mean raising rates a lot, or tomorrow, only that an inflatathon is the definition of a non-solution. The longer we toy with neg rates as a denial strategy, the longer off that day is.

    Oh, and S, money supply is the _least_ important of several inputs to price vectors (unless we’re talking Zimbawaean or post WW I Deutschland level printing)—and our money supply is presently shrinking. Credit availability, credit cost, asset value vectors, and demand vectors are just as significant inputs. Classical definitions are inadequate, which I think you know. ‘Inflation’ is a multi-dimensional state space, and ‘collapsing’ one’s perspective to lower dimensionality only results in distortions; things seem to bounce funny away from analysis for reasons which don’t seem obvious, something symptomatic of inadequate dimensionality in perspective.

  17. S

    Agree the shadow banks are as critical and have provided the lubricant for the debt binge. Agree that credit contraction is equally important just making a simplistic argument definitionally. That said agree deflation is a risk in key wealth creators and inflation in the key everyday items cost of living. A truly deathly combination. rates will never go back up unless the RoW decides to stop funding the US hegemonic system. Until that point (Sester) the paradigm stays. When it does end, the rates are going to blow out and then perhaps you will get your 10% long bond (assume 7% inflation).

    The problem with USD carry trade is where you go for yield. All the usual suspects are having same problems we are only lagged – see comment in FT by Europe industrialists that they will get the disease on 6-12 month lag. Maybe Loony/AUD on a pure hard currency play + responsible central banks. As for the over touted long dollar short euro trade if Trichet sticks to his guns that may be a loser. here is hoping there is some sanity left in the world. The performance of the US Central Bank is an abomination and is worthy of a permanent downgrade.

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