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How Fed Manages to Keep Inflation Fears Under Control

Wednesday, 18 Nov 2009 | 9:40 AM ET

Sometimes stating the obvious and repeating it frequently can be a very effective policy, especially in managing inflation expectations.

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And that’s what the majority of the Federal Reserve’s policy-setting team is doing in dealing with the inflationary potential of the extraordinary monetary and fiscal stimulus at work in the economy.

Key central bank players know that the “Fed’s current monetary policy is inconsistent with its long-term policy of keeping inflation low,” says Bank of America Chief Economist Mickey Levy. “I think it’s important for the Fed to say, 'We know what we're doing, that there are but extenuating circumstances and that we still have our eye on long-term objectives.'”

Fed Chairman Ben Bernanke, Vice Chairman Donald Kohn and San Francisco Fed President, Janet Yellen, who also served as a board governor, have all said as much this week.

“The Fed had made the point that expectations are important,” says Robert Brusca, chief economist at Fact & Opinion Economics. “They affect the way people act.”

And think. And despite a rush into gold, most would say that inflation expectations have been well managed and are under control.

The few telltale signs out there confirm that. Spreads between Treasury Inflation Protected Securities, TIPS, and regular cash-based Treasury bonds and notes of varying duration have drifted between 1.50 percent and 2.0 percent in recent months, which happens to fall within the Fed’s supposedly target range for inflation.

And for all the worry about the Obama administration’s borrowing boom, Treasury auctions have drawn sufficient interest to avoid building a premium into the yields.

“We're a good ways from that happening,” says David Resler, chief economist at Nomura Securities.

The difference between seven months ago and now is notable. Back then, when the Obama administration’s big spending ways were new and all too apparent and there were lingering doubts about the effectiveness of the Fed’s program to buy various kinds of government debt in the markets, yields jumped, with the 10-year note breaking 4 percent in the middle of a brutal recession.

Also back then, market pundits and fiscal conservatives in Congress were doing most of the talking about inflation and driving expectations — higher.

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It was hard to argue with the logic. In the past, easy monetary policy, or government spending, or both raised inflationary expectations and as a result interest rates. It happened during the Reagan and the Nixon administrations in what might be considered more normal circumstances.

It even seemed to be on the verge of happening in the Greenspan-Bernanke handover period at the Fed.

Don’t even think about it now, say most analysts. Not that there still isn’t a vocal minority, which happens to include Fed presidents Jeffrey Lacker, Charles Plosser and James Bullard.

Lacker Tuesday warned that concerns about “lingering weakness” in some areas of the economy are not reason enough to risk an inflationary outbreak.

That group and others may remember the rare times when the Fed got it wrong, such as in the late 70s.

Then, as now, the operative word for the economy is slack. Growth — along with demand — is so weak that price or wage inflation is considered almost impossible. Inventory is sufficient. Hiring unlikely or minimal.

“The Fed's public statements about the slack have helped allay concerns,” says Levy.

What’s more, banks may be sitting on billions of dollars in cheap money, but they are not lending it and consumers are hardly rushing to borrow it. Wages are largely stagnant.

“You’re looking for the beast, but all you have is rhetoric,” says Brusca, describing what some are calling a paradox.

Economists say the Fed appears confident it can withdraw monetary stimulus—especially the unconventional measures — when it needs to, fostering growth and job creation, with inflation remaining subdued “for several years", according to Yellen in comments after her speech Tuesday.

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Bernanke Monday talked about “exceptionally low levels of the federal funds rate for an extended period.”

On the same day Kohn said the Fed needed to be “alert to any tendencies for movements in prices for commodities and assets to result in a sustained increase in inflation and inflation expectations.”

You’d think rhetorical barrages like the past two days would be enough for the markets. And it may be. But in a way even the people calling the shots may need some reassuring and repeating themselves may help.

“We’ve never been through this before,” says Patrick Newport, an economist at Global Insight. “We're not a 100-percent sure this is going to work.”

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