Monday, June 12, 2006

Topping and lagging 

I've read enough about Cleveland Federal Reserve President Sandra Pianalto's remarks on monetary policy that I had to read the actual speech she gave. They are consistent with some of the ideas I wrote last week, in my view, and not at all troubling. I've seen most of the quotes from her talk working practically backward. Grab any source on the story and see if you agree.
What about our objective of price stability? Inflation rates can be affected by all kinds of unusual events in the short term, especially large swings in energy prices. Of course, all of us are painfully aware of the huge increases we have seen in energy prices. We feel it every time we fill up our gas tanks. Americans are complaining that the energy-price increases have hit them hard - and they're right. The price of a barrel of oil has gone from about $20 in 2002 to roughly $70 today.

Price pressures are also being felt across an array of other commodities, goods and services. As a result, the core rate of inflation has also been edging up lately. The Consumer Price Index has increased by 3.5 percent during the past year. The so-called core rate - that is, the CPI excluding food and energy - hasn't risen as much: It rose slightly more than 2 percent during the past year. But the core CPI has increased at an annualized rate of more than 3 percent during the past three months. This inflation picture, if sustained, exceeds my comfort level.

Fortunately, the public is, for the most part, looking at this disappointing inflation news as a transitory development. Measures of long-term inflation expectations have been mixed lately, but, on the whole, I regard them as remaining contained. The FOMC's challenge is to make sure that they stay contained.

The recent news on inflation troubles me, but the news has not come as a complete surprise. Last year I began to anticipate that we might confront some disappointing inflation data in the first half of this year, although I was not expecting quite as much inflation as we have seen. Still, I have been expecting price pressures to diminish.

This juncture in the policymaking process is the most difficult. There is, after all, a time lag between monetary-policy actions and their ultimate effect on inflation. That is, even though the recently reported inflation numbers have been edging upward, I think that the current 5 percent level of the federal funds rate is near a point that is consistent with a gradual improvement in the inflation outlook.
This might help illustrate the problem David Altig pointed out last week. Pianalto says inflation expectations are still good, and declares it is "[t]he FOMC's challenge is to make sure that they stay contained." She then appeals to the lag between enacting monetary policy and seeing changes in the economy. But the view that what is targeted is inflation forecasts and not the rate itself should mean that, if she's serious that she sees inflation expectations as "remaining contained", then as long as one does not disappoint the markets regarding rate increases all should be well. And apparently the market thinks the quarter-point rise is coming. The pause, if it is to be, comes in August.