A Cat amongst the Pigeons

More tough talk was heard yesterday from the Federal Reserve. According to this story($) in the Wall Street Journal, William Poole, president of the Federal Reserve Bank of St. Louis has about had it with the "inflation wimp" tag that has been applied to the boys (and girls) in the big leather chairs that meet every six or seven weeks to set short-term interest rates.

It seems they're ready to bring the entire world economy down in order to get core inflation back to two percent.

"If inflation turns out to exceed ... our target range, I do not believe we can count on a slowing economy to bring inflation down, by itself, quickly," William Poole, president of the Federal Reserve Bank of St. Louis, said in an interview. If inflation expectations rose in "a persistent way...we could expect to see that show up in measured inflation in fairly short order."

Mr. Poole said to keep expected inflation from rising further, the Fed needs "an upside bias" in setting interest rates.

Mr. Poole, who has held his job since 1998, has long been on the hawkish side of the policy-making Federal Open Market Committee. The FOMC consists of seven Washington-based governors and 12 regional-bank presidents, of whom five vote in a given year.

Nonetheless, Mr. Poole's remarks echoed Fed Chairman Ben Bernanke, who on Monday indicated he is more concerned about the recent rise in inflation than signs of slowing economic growth. Mr. Bernanke's remarks prompted futures markets to sharply increase the odds that the Fed will raise its short-term interest-rate target to 5.25% from 5% at its meeting on June 28-29. Mr. Poole's remarks, made in an interview Monday and published yesterday on WSJ.com and Dow Jones Newswires, caused those odds to rise further, to 80% from 72% Monday and 48% Friday.

The tough talk is certainly having an impact on financial markets, however the combination of the lagged effect of previous rate moves and a long history of the Fed tightening too much has to weigh on the makers of monetary policy going into another election this fall.

Everyone understands high gas prices, while virtually no one understands high health care costs, but few blame the Fed for the pain at the pump or their higher co-pays. When consumer confidence polls show expected inflation increasing to five percent or more, why should this be a cause for concern? People's homes are still increasing at twice that rate, and have been for years - no one ever complained about reigning in those price increases.

And you can still buy lots of imported goods at low prices at your favorite Big Box retailer.

Apparently the "inflation expectations" concern is based on studies, by none other than new Fed Chair Ben Bernanke, showing that long term economic growth is enhanced when people believe that prices are not rising too quickly.

When the public expects higher inflation, it may set prices and wages in a way that makes that expectation a reality. Mr. Poole said that effect is more powerful than the "output gap," the idle capacity that exists when the economy is operating below its potential. "If inflation expectations were to rise ... it might take a very long time before the [output gap] would be able to offset what's going on with inflation expectations."

Mr. Poole noted that investors' expectations of inflation, judging from the behavior of inflation-protected Treasury bonds, have risen about 0.2 percentage point this year. "It's not a huge number, but from my perspective, it's going in the wrong direction" because inflation is already "at the upper end of what I would like to see." Many officials say they prefer that inflation, by their favored price index, remain between 1% to 2%, which Mr. Poole called a "fully acceptable range," though he personally would prefer a lower target. By that measure, inflation was 2.1% in April.

Analysts say Mr. Bernanke's speech may in part have been meant to squelch doubts of his willingness to administer tough anti-inflation medicine. If so, he appears to have succeeded.

With the release of yesterday's consumer credit report, where outstanding consumer installment credit increased at three times the expected rate, this tough talk would be better described as anti-economy medicine.

Americans like their credit plentiful and cheap - it's our birthright.

With the release, later today, of the Federal Reserve's Flow of Funds report, there will surely be more indications of an insatiable appetite for debt in the U.S.

Does Ben Bernanke realize that the U.S. economy, and hence the entire world economy, is based on easy money?