Comment on WSJ: Fed and inflationary expectations

Fed Acknowledges Inflation Hawk Concerns

By Jon Hilsenrath

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

Fed Chairman Ben Bernanke. (Reuters)

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.http://blogs.wsj.com/economics/2009/09/23/fed-acknowledges-inflation-hawk-concerns/

My comment:  Price levels result from the intersection of demand and supply. Aggregate demand in the U.S. increases with an increase in purchases by consumers, businesses, or government, and with an increase in the money supply (yes, money SUPPLY). The aggregate supply curve is basically the marginal cost curve of the economy, or the sum of the cost curves of all firms in the economy. It is driven by productivity and wage rates; more productivity, lower costs, and a downward shift in supply, pushing GDP up and the price index down. Lower efficiency and/or higher wage rates result in higher costs, a shift up in the supply curve, and a higher price level. Slack refers to "unused capacity," generally unused plant or physical capacity. But slack also results from "unused labor capacity," i.e., unemployment. There is no question that the U.S. economy currently has significant slack in both areas. This basically means that the short run supply curve is relatively flat; that a given increase in demand can be met by an increase in quantity supplied with minimal increase in prices. But that is not the end of the story. There are two additional factors that must be considered. One, the fed reserve is in unchartered territory right now, underwriting record increases in the money supply, which translate into unknown but potentially monstrous increases in aggregate demand. Unless the long run supply curve is flat, which it certainly is not, this is inflationary. Two, there is some evidence, though not entirely convincing, that expectations of inflation lead to increases in wages, but this is generally only after the economy experiences repeated bouts of unanticipated inflation. So, the bottom line is that supply and demand drive equilibrium output and price, as always, and that inflation will in fact result if the increase in demand continues to outstrip the increase in supply in the economy.

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