Tea Leaf: The Fed plays with fire on inflation

Published: Tuesday, Feb. 22 2011 4:35 p.m. MST

"It's hard to get the toothpaste back in the tube when it's already out."

U.S. and global inflation pressures are on the rise. This is not to say that rampant U.S. inflation reminiscent of the late '70s/early '80s is upon us … nothing of the kind. However, prices are going higher.

The Consumer Price Index (CPI) rose 0.4 percent during each of the past two months, the largest consecutive monthly gains in two years. The CPI has now risen 1.6 percent during the most recent 12-month period, with modestly higher inflation likely during 2011 and 2012.

Rising commodity prices for, well, most everything, are now occurring. Higher prices are found for oil, steel, copper, silver, cotton, coffee, most agricultural commodities, etc. Many American companies are now in a process of boosting prices modestly at the retail level to compensate for their own higher raw material prices.

"Having a little inflation is like being a little pregnant."Dian Cohen

Avoiding deflation

Ironically, a slightly higher level of inflation has been a goal of the Federal Reserve during the past two years. I guarantee you that the Fed has been more concerned about prospects for deflation than inflation since 2009.

History tells us that dealing with deflation — declining prices, followed by declining incomes — is a more difficult challenge than is dealing with inflation. Just ask the Japanese. The Fed made a conscious decision not to go there.

The Federal Reserve is on record as to the desirability of inflation running 1.5 percent to 2.0 percent annually. Such a level allows for both modest price increases and modest wage increases. The challenge is not letting inflation pressures escalate from there.

"Inflation is when you pay $15 for the $10 haircut you used to get for $5 when you had hair."Sam Ewing

Fed challenge

One major factor will make life very challenging for the Fed during the next 2-3 years. The Fed's most important interest rate, the federal funds rate, has been at an all-time low target level of 0 percent to 0.25 percent for the past 26 months. In addition, the Fed's two programs to purchase roughly $2,000,000,000,000 in U.S. mortgage-backed securities and U.S. Treasury notes, affectionately known as QE1 and QE2, have provided even more monetary stimulus (more toothpaste).

At some point, perhaps a year from now (if not slightly sooner), the Fed will face greater inflation anxiety and will need to unwind the unprecedented monetary stimulus now in play. Such moves will be largely welcome by financial market players, who have a real distaste for inflation.

However, how will members of the U.S. Congress react, particularly in light of a still high level of unemployment at that time? The Fed is, after all, a creation of the Congress.

Rising global inflation

Inflation pressures are higher around the globe than within the U.S. Chinese prices are 4.9 percent higher than a year ago, while food and most energy prices have risen sharply in dozens of lesser developed nations.

One contributor to higher global and domestic inflation is strong economic growth. Stronger growth leads to rising demand for basic commodities and materials, leading to rising prices.

Keeping the lid on inflation will be a major task for the Fed … stay tuned.

Fragile confidence

U.S. consumer confidence rose to the highest level in three years in February, one more positive sign for economic growth prospects. Unfortunately, the latest laundry list (say that three times quickly) of headwinds is likely to dampen the good news.

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