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Why Fed's Bernanke May Be Right On Inflation —So Far

The modest rise in April consumer prices was pretty much as expected, suggesting Federal Reserve Chairman Ben Bernanke might have the inflation story right on two fronts: that the recent run-up in the headline rate is transitory and that high oil and food prices are unlikely to spill over into other prices.

Federal Reserve Bank Chairman Ben Bernanke
Pablo Martinez Monsivais
Federal Reserve Bank Chairman Ben Bernanke

As a result, Friday's consumer inflation report keeps the Fed on track to gently change its message this summer but not really change policy until the early winter of 2011 or even 2012.

Headline inflation—which includes food and energy—topped 3 percent for the first time in two and half years. If that was where core inflation—which excludes those volatile sectors—was headed, the Fed would have a problem.

But driving headline inflation was a 3.3 percent rise in gasoline prices and a 0.8 percent rise in overall commodity prices. Also powering the overall number is a 1.2 percent gain in used vehicle costs.

By contrast, trip out food and energy and the core rate is up just 1.3 percent. This is more than twice the rate from October, but is well below the 2 percent or so mark the Fed is seeking.

In fact, the Fed embarked on its quantitative easing strategy in October, when core inflation was just 0.6 percent. Even headline inflation back then was 1.17 percent.

The Fed will not be spooked having achieved what it set out to achieve—to reflate the sluggish economy gradually—and will breath a sigh of relief now that some of the froth has come out of the oil market.

Oil prices are off about 10 percent from their April average and gasoline prices should start to come down as a result. June’s inflation numbers should reflect this giving the central bank some time to chew over its next policy step.

The trouble for the central bank is that is has very much the same policy in place that was used to avoid deflation. But at the current rate of growth, around 0.2 percent monthly, core inflation will hit 2 percent around October or November.

If current trends continue, this will be a summer of a gentle course change at the Fed.

It will amble up to a policy of halting its reinvestment of the funds from securities that mature or are pre-paid. It will ease out of its extended period language. The Fed could even announce a long-term plan to reduce the size of its balance sheet and raise interest rates.

But 0.2 percent monthly gains in the core that doesn’t raise the overall core rate to 2 percent until the fall will give the central bank time.

The key is the Fed is going to be ending its pre-commitment to keep policy easy but not necessarily tightening policy quickly. There’s nothing about today’s numbers that suggest any real tightening (other than verbal tightening) until late this year or early 2012.

If Bernanke turns out to be wrong, and the core rate starts rising at a faster pace than 0.2 percent, look for the Fed to accelerate its timetable.