In insisting that inflation is under control while reiterating his inclination to cut interest rates, Federal Reserve (Fed) chairperson Ben Bernanke walks an increasingly wobbly tightrope. If reported inflation continues to rise, a buyer’s strike in the treasury market can’t be ruled out. That would lead to a curtailment of Bernanke’s Fed tenure.
Bernanke’s testimony to Congress included a “soft” inflation target of 1.5-2% with a time horizon of 2010. Since the Federal Open Market Committee (FOMC) members expect muted pressures on resource utilization, and the core “personal consumption expenditure (PCE)” deflator (Bernanke’s favoured inflation measure) for thefourth quarter of 2007 was only 2.1%, this target is at first sight plausible.
On inspection, however, it fails the smell test. Consumer price inflation is currently 4.3%, well above both short- and long-term interest rates, suggesting that inflation may well accelerate further. Commodity prices have surged and are now feeding into “crude” and “intermediate” producer price indices, and must surely appear in the consumer price index and Bernanke’s beloved PCE—a measure of price changes in consumer goods and services—deflator soon.
Bernanke, in his semi-annual Humphrey-Hawkins Act testimony before Congress, announced that FOMC participants were targeting a core PCE inflation rate of 1.5-2% in two years, as they expect pressures on resource utilization to be muted. Bernanke emphasized that downside risks to US economic growth remain. According to the Federal funds futures market, the probability of a 0.5% cut to 2.5% in the Federal funds target at FOMC’s 18 March meeting exceeds 90%.
The producer price index (PPI) for finished goods rose by 1% in January 2008; it was 7.4% above its level in January 2007. PPI for intermediate goods rose by 8.8% over the previous year, that for crude goods by 31.3%. The consumer price index for January 2008 was up 4.3% over the previous year. New home sales in January 2008 fell 2.8% to a seasonally adjusted annual rate of 588,000—down 34% from the rate in January 2007. The median new home price fell by 15%.
Durable goods orders fell 5.3% in January 2008.
China, formerly a source of deflation through cheap exports, is now pushing prices up, since its own inflation is more than 7% and its currency is rising steadily. Should reported inflation continue rising, it will force bond yields up and prices down. At some point, that would cause a “buyers’ strike” in which prices would fall sharply and the treasury would be unable to carry out its periodic long-term bond auctions. That would bring a call from the bond markets for a new Fed chief and monetary policy. In 1979, Fed chairman G. William Miller was forced out of office by such a crisis and replaced by the deflationary Paul Volcker.
Such a scenario would put Bernanke’s reappointment, when his term expires in January 2010, at risk. Presidential hopefuls John McCain and Barack Obama have both been careful to avoid criticizing Fed policy. However, McCain is a fiscal and monetary hawk, who might favour a Volcker-style policy against inflation. It’s only natural that Obama or Hillary Clinton would want their own Fed chairperson, not a protégé of their Republican predecessor. Bernanke may want to get started on those memoirs soon.