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My Two Cents

The Fed Stays Pat

Chris Farrell May 9, 2007

There was no surprise that the Fed stayed pat on monetary policy at this week’s Federal Open Market Committee meeting. Inflation remains the Fed’s “predominent policy concern”. Perhaps the next move by the Fed is even to hike its benchmark interest rate..

Problem is, what inflation? The core rate of consumer price inflation is trending lower (core means the inflation measure minus volatile food and energy prices). The core personal consumption expenditure price index–a broadbased guage of inflation pressure–is running at a 2.1% rate year over year. That’s down from 2.4% pace the previous month. The Fed is tight with the growth in the monetary base close to record lows, according to data from the Federal Reserve Bank of St. Louis. Companies find it tough to hike prices with the international and domestic compeition for markets and profits fierce.

I’d go farther and argue that we really haven’t had inflation for some 25 years. All we’ve had is some hikes in the headline consumer price index and producer price index whenever oil prices spike.

So, why does Bernanke keep worrying about inflation? He’s making a “Pascal’s wager” with monetary policy. Pasal was a 17th century philosopher and mathematician. He’s famous for arguing that after weighing the risks it paid to assume that God exists. Peter Bernstein, the current dean of finance economists, notes that you can’t get rid of uncertainty when making decisions. Instead, Pascal’s insight was to focus on the how serious the consequences could be if you turn out to be wrong. “Consequences are more important than probabilities,” he told journalist Jason Zweig several years ago.

The probability of inflation taking off is small. But Bernanke knows that if inflation does soar the consequences are dire for the central bank’s credibility. Long-term interest rates will rise and the economy tank. The Bernanke Fed is building up its inflation fighting credentials.

Still, my concern is that the Fed will stay too tight for too long. Put it this way: why is the market convinced that a 2.1% inflation rate is ominous but a 1.9% pace is okay? With either number, inflation isn’t a concern.

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