Trichet Shows Up Bernanke on Inflation? Say It Isn't So!

Jean-Claude Trichet
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Jean-Claude Trichet

While Fed Chairman Ben Bernanke maintains allies at the top of the central bank, finding support in the financial community is getting progressively tougher.

Thursday’sEuropean Central Bank decision to raise interest rates, though long expected, nevertheless offered a potential embarrassment: Officials from the home of the sovereign debt crisis schooling the US central bank head on inflation.

True, economic conditions differ between the US and Europe, where inflation pressures are far more tangible at this point. But the subliminal message from ECB President Jean-Claude Trichet was unmistakable: We care about inflation and you don’t.

“I would say that it’s both sad and pathetic that we’re comparing ourselves to the French on the European side in terms of leaning to the right and raising rates in the face of this kind of inflation,” complained Keith McCullough, CEO of Hedgeye Risk Management, in a CNBC interview.

Trichet was clear in what he intended by raising refinancing rates by a quarter point to 1.25 percent, citing “broad-based inflationary pressures over the medium term.”

“Compare that to our conflicted and compromised chairman who assured that inflation is ‘transitory’—with the same conviction he proclaimed that the subprime mortgage crisis was contained,” quipped Michael Pento, senior economist at Euro Pacific Capital, in a blog post. “Yes, Americans are now being schooled by the French on how to run a sound monetary policy.”

For Bernanke, the scrutiny comes at a critical time when he seeks to assume the “maestro” mantle bestowed on his predecessor, Alan Greenspan. Though Greenspan's critics vilify him now for creating the easy-money conditions that led to the subprime crisis, through the earlier part of his term he received widespread praise for his ability to maintain the Great Moderation and its balanced strengths.

But with food andenergy prices surgingand little inflationary relief ahead, Bernanke faces the challenge of how to bring down commodity prices without spooking the stock market.

Raising asset prices, particularly stocks, was a primary goal of the Fed’s quantitative easing program and has been a major factor in the perception that the economy is recovering. In addition to providing liquidity to institutions to buy up stocks, QE also has kept borrowing costs low and helped open up the corporate bond market.

However, it simultaneously has resulted in keeping the dollar cheap, a primary driver in the inflation equation.

In making his remarks that consumer price increases were “transitory,” Bernanke disregards price trends.

Joseph LaVorgna, chief US economist at Deutsche Bank , points out that history strongly suggests that increases in food and energy prices—part of the “headline” inflation numbers that government economists usually disregard but consumers feel deeply—are rarely transitory.

“[W]e have found that barring recession periods, food and energy prices almost always rise over an extended period,” LaVorgna, along with Carl J. Riccadonna, Deutsche’s senior US economist, wrote in a note to clients. “In point of fact, the last time that food and energy prices, as measured in the consumer price index, declined over any three-year period was June 1988.”

The Deutsche team also takes issue with other Fed statements, such as the belief that inflation expectations are within historical norms. They point out that the latest University of Michigan survey shows expectations the highest since August 2008.

That’s significant because the economy then was traveling in a different direction—down—than the economy now.

“Thus, in our view the probability of a further increase in longer-term inflation expectations is rising—particularly if near-term inflation expectations continue to drift higher,” the note said.

Inflation expectations, indeed, are trending higher.

Five-year breakevens—the difference between nominal Treasurys and inflation-protected notes—are near 3 percent and trending higher. That may not sound so bad now, but unless Bernanke is unable to talk down inflation, expectations are likely to get a whole lot uglier, and soon.

“While some policymakers expect recent price pressures to be transitory as a result of slack in the labor and product markets, one can observe that 1-year inflation expectations generally do not decelerate unless energy prices lead the way,” the Deutsche team wrote. “So unless oil prices dip sufficiently to unwind the recent uptrend in retail gasoline prices, inflation expectations are unlikely to retreat.”


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