"Who gives a damn about inflation" ... not the Fed! (amv)

Wolgang Münchau has written a very insightful post which is worth being quoted at full length:

Who gives a damn about inflation?

There was a time when left-leaning economists argued that they rather had 8% inflation than 8% unemployment. We have not heard that line of argument for a long time. Our celebrated Age of Moderation in combination with some fiddling of inflation statistics has meant central banks could not generate official inflation even if they wanted to. So, while desperate economists previously had to dig out the Phillips curve to make their case, they could suddenly have their cake and eat it. While the good times lasted, everybody became an inflation targeter.

Now that the age of moderation has ended, we are returning to Phillips curve-type discussion. The Fed's rate is a clear case in point. I never suspected that Ben Bernanke or Frederic Mishkin care even a jot about inflation. They have talked about it, but he have shown zero commitment to hold inflation to the Fed's comfort zone, which is 1.6-1.9% (it used to be 1-2%). Core inflation has exceeded this zone for over three years, with a rising tendency. Worse, US headline inflation runs at over 4 per cent, and if you take the old pre-Boskin inflation measure, US inflation would not be over 7 per cent. (That is not too long ago. This is the inflation measure used during the Clinton era). The Boskin Commission report introduced the principle of hedonic pricing, i.e. prices per utility consumed, so that technical progress at constant nominal prices enters into the index as a fall in prices. If you distrust such adjustments, as I do, you could in fact argue that reckless monetary expansion only caused asset prices inflation, but also actual inflation. It is no surprise that we are observing everywhere in the world that people "feel" to be higher than the officially measured rates.

But even if you accept the official measures as given, the rate cuts cannot be defended either in terms of actual inflation, which is elevated, or expected inflation, which is even more elevated. The only argument one can make, and which the Fed is making, is that you can temporarily deviate from an inflation target to pursue other goals, as long as this deviation is temporary, and as long as you retain credibility. Judging by euphemistic bond markets, the Fed still has some credibility (which will last right until the moment when it suddenly disappears). I also doubt this rate cut is going to be temporary. I don't believe that the Fed will be in a position to raise rates just as aggressively when this episode is over. On the way down, the argument will be: We must avoid a recession at all costs. If the Fed were to raise interest rates by 1.25 percentage points in the course of one week, it could easily trigger a securities market meltdown. The argument then will be: We must not endanger the economic upswing. Once you drop the inflation anchor, there are always good reasons not to raise interest rates. So I am very sceptical about any claims that rate cuts can be temporary. Also, if that were true, why should people borrow at low variable rates if they expect these rates to go up very soon? It does not make sense. Rate cuts will only have the desired effect if they remain low for some time.

One question I am asking myself - and I am not generally a conspiracy theorist - is whether the Fed reluctantly accepts the rise in inflation, or whether a rise in inflation is actively pursued. In a country with a negative savings rate, there is not going to be much opposition from bondholders, and rising inflation is the most painless way out of a debt crisis - painless of course only in the short run. The big losers in the short-run will be foreign central banks and other foreign investors, but who cares about those?

So the credit bust of 2007 is very likely to followed by the granddaddy of all financial crises, a bond market meltdown that will severely shake investor confidence in the US for a long time to come. So this is the Arthur Burns Fed all over. I am just not sure there is going to be a Paul Volcker to come next.