Tough Talk or Tough Love?

In the scheme of things, tough talk about "inflation" will have little effect on what happens in the U.S. and world economy over the coming months and years - too much of the outcome is already "baked in the cake". While economists can prattle on about "core inflation" or any other measure of consumer prices that may or may not bear any relationship to what consumers actually pay for things, this is much more a story of the declining value of the U.S. dollar, a decline that now appears to be accelerating.

Nevertheless, the "inflation" discussion that was prompted by yesterday's hawkish remarks by Fed Chairman Ben Bernanke, and the response by financial markets, are certainly fun to watch.

In trying to make sense of yesterday's speech, a chart of the daily change to the Dow Jones Industrial Average and a marked up copy of the three month core inflation numbers from the Bureau of Labor Statistics were whipped up.

The idea?

To have a look at what effect all this talk about "inflation" is having on stocks and to see how unusual the inflation numbers are - to try to judge whether all the gyrations that equity markets are experiencing is warranted.

The chart of the Dow over the last three years clearly shows the effect that the new Fed Chair is having on the share prices for thirty of the largest publicly traded companies in the world. Over the last three years, three of the worst five days for the Dow have occurred in just the last couple weeks. Four of the five worst days have occurred with Ben sitting in the big chair or getting ready to.
Recently it's been the question of his inflation fighting credentials and his communication skills. There have been weak economic reports, then talk about pausing, then a misunderstanding, then the Maria Bartiromo incident, then tough talk about inflation, then more weak economic reports, then tough talk about inflation.

It's enough to wear you out if you own lots of ExxonMobil and GE and have been waiting patiently for the Dow to poke through its 2000 high.

Why not just change how "core inflation" is calculated once again and let everyone get on with more of the "asset inflation" that we have all come to know and love?

So what about the inflation numbers cited in yesterday's speech? All this talk about core inflation, of energy prices "feeding into" the core, about underlying inflation, about rising inflation expectations. From the speech, the key passages were as follows.

Consumer price inflation has been elevated so far this year, due in large part to increases in energy prices. Core inflation readings--that is, measures excluding the prices of food and energy--have also been higher in recent months. While monthly inflation data are volatile, core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth. For example, at annual rates, core inflation as measured by the consumer price index excluding food and energy prices was 3.2 percent over the past three months and 2.8 percent over the past six months. For core inflation based on the price index for personal consumption expenditures, the corresponding three-month and six-month figures are 3.0 percent and 2.3 percent. These are unwelcome developments.
...
Therefore, the Committee will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained.

Uh-oh. It looks like the "inflation vigilantes" at the Fed are going to run us into a ditch again.

It's not as if home builders are going to saw up two-by-fours and send truckloads of them to the Federal Reserve building in Washington D.C. because interest rates are too high for people to afford to buy houses. That's what happened to Paul Volcker in the 1980s when he was pushing rates well into the double digits.

We as a country can't handle that kind of tough love, and Ben Bernanke is not the man to deliver it.

Tough talk - yes. Tough love - definitely not.

Besides, the "core inflation" numbers aren't that bad. He seemed to be concerned about the three month 0.8 percent rise that works out to be an annualized rate of around three percent, well above the two percent comfort level for the "core" rate. But, from a historical perspective, a 0.7 or 0.8 percent increase over 3 months is not that big a deal - look how many times it's happened in the last ten years.
This is not really a story of the Fed losing control of inflation. This is much more a story of the Fed losing control of inflation "expectations" due to high gas prices and that pesky owner's equivalent rent that makes up thirty percent of the figure. High gas prices are largely due to ethanol delivery problems at the refineries, which should soon pass, and now that home prices have about peaked, maybe it's time to revisit the whole owner's equivalent rent issue - maybe home prices really should be used for the "inflation" calculation.

In response to a question from a recent appearance before Congress, Ben Bernanke himself stated that the current calculation for consumer prices overstates inflation by nearly one percent.

It's pretty clear where this is all going. Whether recent comments indicate another quarter point rate hike is in the works for later this month or not, what we should expect from Ben Bernanke is much more "tough talk" than "tough love".