By Steven K. Beckner

(MNI) – For the past two years, the Federal Reserve’s choices have
been relatively simple: both economic activity and inflation have fallen
far short of the Fed’s objectives, justifying highly accommodative
monetary policies for most policymakers.

But that is starting to change. Disinflation has given way to
unmistakable price pressures, and there has also been an upsurge in
inflation expectations.

If these trends continue in coming months, the Fed could find
itself in a dilemma it hasn’t faced for some time. For while there have
been improvements in growth and job creation, the economy continues to
operate well below its potential in the minds of most Fed officials even
as inflation creeps higher.

Since Feb. 7, MNI has reported that “better data have caused a
subtle shift in how the balance of risks to the economy are viewed at
the Federal Reserve.” On Monday, a day before the Federal Open Market
Committee met for the second time this year, MNI reported again that
“there has been a subtle shift in Fed officials’ thinking and commentary
on the economy and inflation — not just a more upbeat tone on the
outlook for growth and jobs, but also slightly more acknowledgement of
public inflation concerns.”

The FOMC confirmed that policymakers’ perceptions have changed in
its Tuesday afternoon policy statement, altering its evaluation of both
sides of its statutory “dual mandate.”

On the growth and employment side, the FOMC said the recovery is
“on a firmer footing,” cited improving labor market conditions. It
stopped saying that progress toward its objectives of maximum employment
with price stability had been “disappointingly slow.”

On the inflation side, the FOMC did not swing entirely toward
concern about price pressures, but it did make a significant move in
that direction.

In its Jan. 26 statement, the FOMC had said, “Although commodity
prices have risen, longer-term inflation expectations have remained
stable, and measures of underlying inflation have been trending
downward.”

On March 15, by contrast, the FOMC dropped its reference to
disinflation and acknowledged that risks had shifted to the upside:
“Commodity prices have risen significantly since the summer, and
concerns about global supplies of crude oil have contributed to a sharp
run-up in oil prices in recent weeks. Nonetheless, longer-term inflation
expectations have remained stable, and measures of underlying inflation
have been subdued.”

The FOMC went on to repeat that “measures of underlying inflation
continue to be somewhat low, relative to levels that the Committee
judges to be consistent, over the longer run, with its dual mandate.”
But it added, “The recent increases in the prices of energy and other
commodities are currently putting upward pressure on inflation. The
Committee expects these effects to be transitory, but it will pay close
attention to the evolution of inflation and inflation expectations.”

Since the FOMC met, Labor Department price indices have validated
public and Fed inflation worries.

First, the Producer Price Index was reported up 1.6% in February,
more than twice as much as expected. It wasn’t surprising that the
energy component jumped 3.3%, but there was also a whopping 3.9% leap
in food prices. Excluding food and energy, the core PPI for finished
goods was up 0.2% — 1.8% compared to a year earlier.

Thursday morning, the Consumer Price Index also came in higher than
expected by both measures. It was up 0.5% overall and, for the second
straight month, 0.2% on a core basis. The core CPI is still up just 1.1%
year-over-year, but that rate has been moving higher. In December the
year-over-year figure was just 0.8%.

A little later Thursday, the Philadelphia Federal Reserve Bank’s
March survey found a further increase in its prices received index to
22.6 — up from 21.0 in February, 17.1 in January and 10.7 in December.
Before that the index was in negative territory.

Inflation expectations have also been climbing. The break-even
“inflation compensation” spread between regular Treasury and inflation
protected securities has widened from 161 basis points when Fed
Chairman Ben Bernanke began heralding the resumption of
quantitative easing last Aug. 27 to as much as 255 basis points
last week. The spread now stands at 242.

The University of Michigan’s consumer sentiment survey
shows Americans now expecting inflation to average 4.6% over the
next 12 months compared to 2.7% last August.

While Dallas Fed President Richard Fisher and Philadelphia Fed
President Charles Plosser, both FOMC voters, have pointed to rising
inflation and inflation expectations with some alarm, members of the
majority have until recently downplayed inflation risks or even welcomed
increases from dangerously low levels.

Bernanke, for example, told the House Budget Committee on Feb. 9
that TIPS spreads had only risen “from very low levels to normal
levels.”

But it is becoming increasingly difficult for Bernanke and his top
lieutenants to dismiss public and market inflation fears, some of which
are being fuelled by political timidity in dealing with a federal
budget deficit projected at $1.65 trillion this year.

When New York Fed President William Dudley told the Queens Chamber
of Commerce last Friday that they should look at falling iPad prices and
not just rising food prices, members of the audience groaned, and one
person spoke up to ask Dudley whether he had “shopped for groceries
lately.”

But after saying that inflation was still “below levels consistent
with our dual mandate objectives,” cautioning against “overreacting” to
commodity price rises and predicting “slack” will keep dampening price
pressures, Dudley felt compelled to bow to inflation concerns. “Fed
policymakers “always need to be careful about inflation — even in an
environment of ample spare capacity,” especially since oil and other
commodity prices are surging, the FOMC vice chairman said.

Dudley had previously said all members of the FOMC understand that
“allowing inflation to gain a foothold is a losing game with large costs
and few, if any, benefits.”

The FOMC obviously felt it had no choice on Tuesday but to elevate
its own level of concern about inflation in order to convey its
collective committment to preserving price stability. And it can be
expected to continue to do so until such time as oil and other prices
recede. As MNI has been reporting for some time, the FOMC is likely to
communicate further about its “exit strategy” planning.

But beyond giving reassurances, it will not be easy for the Fed to
act preemptively against inflation. Although unemployment nominally fell
to 8.9% in February, it is widely recognized that real joblessness is
running much higher after allowing for declines in labor force
participation due to discouragement and for the vast number of people
who have had to settle for part-time work.

Real GDP growth of 2.8% in the fourth quarter, though better, is
still too slow to return the economy to full employment over the
forecast horizon. The FOMC projects that the unemployment rate will
still be 7.6% to 8.1% in the fourth quarter of next year.

Even if “structural unemployment” has pushed the “natural” or
“non-accelerating inflation rate of unemployment” up a percentage point
or two, as the fed concedes, that would still leave a lot of slack in
the labor market.

This week’s econommic data underscore the continuing challenges
facing the U.S. economy. Although February retail sales were up a
gratifying 1%, housing starts plunged 22.5% and industrial production
0.1%.

Downside risks from the Middle East, Europe, indebted states and
now Japan add to arguments for maintaining a stimulative monetary
policy. High oil prices are draining consumer purhcasing power while
adding to business costs, and net exports are under threat from economic
weakness in a key trading partner.

And so, other things being equal, if Bernanke, Dudley, Vice
Chairman Janet Yellen and others had their druthers, they would probably
prefer to keep policy accommodative for a lengthy “extended period.”

The question is whether inflation will allow them to do so.

The worst of all possible worlds for the Fed would be a
“stagflationary” environment of rising inflation amid continued high
unemployment.

That would be a tough one, but given a choice between making policy
less accommodative and watching inflation accelerate above the FOMC’s
implicit 1.6% to 2.0% target range, the FOMC would likely feel it has no
real choice but to err on the side of restraining price pressures. To do
otherwise would risk a counteproductive escalation of inflation
expectations that would drive up long-term interest rates.

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** Market News International **

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