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FOMC Statement: Inflation Is The Key

In a counterpoint to the jump in housing starts reported Tuesday morning, the afternoon brought a reminder of the broad weakness in the U.S. economy with the release of the minutes of the latest Federal Open Market Committee meeting. The crucial comment is on inflation (the emphasis is mine):

The Committee ... is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.
The words seem to say that the Fed won't act unless there is more bad news, but economists figure keeping interest rates low (through so-called quantitative easing, or QE) is a given. Agreed -- it's time to pour on the coal, and give consumers and businesses every chance to pick up the pace on spending. A little inflation would be a small price to pay.

There's an important difference in the wording of yesterday's release, and Chairman Ben Bernanke's comments at the Jackson Hole pow-wow in August. As the Financial Times points out:

[At Jackson Hole] Mr Bernanke said the Fed was prepared to act "if it proves necessary, especially if the outlook were to deteriorate significantly". Many observers read this as meaning that the Fed would only restart quantitative easing if the economic data got quite a lot worse.
Yet on Tuesday the FOMC simply said it was prepared to act if needed to support the economic recovery. There was no qualifier. That implies that the significant deterioration Mr Bernanke talked about is a sufficient condition for the Fed to launch QE2 - but is not a necessary condition.
QE is a new tool for the Fed. Traditionally the central bank tries to stimulate or contract by lowering or raising short-term rates. In QE, the Fed buys longer-term government and mortgage bonds to keep interest rates low at the far end of the yield curve. The Fed has bought $2 trillion of bonds, and said yesterday it would not raise that amount, but would keep buying new bonds as it receives principal payments on the current holdings. Whether it's the result of QE or not, mortgage rates are very low:

Click on the graphic for a larger image
One Fed governor, Thomas Hoenig of the Kansas City branch, has been against further easing on the grounds that the recovery is proceeding well, and it would embed higher inflation in the U.S. According to the Fed release:

[H]e believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and will lead to future imbalances that undermine stable long-run growth. In addition, ... Mr. Hoenig did not believe that continuing [quantitative easing] was required to support the Committee's policy objectives.
The markets are worried about inflation too. Yesterday and this morning gold has traded up, on thinking like this, from money manager Peter Schiff (via The NY Times):
"Moments after the statement, gold surged to a new record, and all foreign currencies spiked. Given that Bernanke is now explicitly committed to inflation, investing in gold and foreign currencies becomes an easy decision."
The Times blog is worth a look -- it quotes many other economists as well, including my MoneyWatch colleague Mark Thoma:
[T]here are two reasons to act now, to help employment markets that are still in shambles, and to ensure against another downturn in the future, or what I think is more likely, to ensure against extended stagnation. Instead, the Fed seems to be resigned to a wait and see approach that accepts a slow, plodding, agonizing recovery for the unemployed.
Inflation has been very low:

Click on the graphic for a larger image
If further easing helps us to avoid another slowdown, or as Mark posits, an extended slump, I think a little inflation is a small price to pay. Besides, with the demands on resources so low now, the Fed will see any inflation coming from miles away, and be able to head that off.

P.S.: The New Yorker of September 27 contains a cogent piece by James Surowicki on inflation. Here's a sample:

Right now, the U.S. economy has two fundamental, and interconnected, problems. First, consumers face huge debt left over from the borrowing spree of the past decade. Second, the dominant sentiment is caution-consumers are hesitant to spend, and businesses are hesitant to expand, invest, and hire. If the Fed were to moderately raise its inflation target-currently around two per cent-and commit itself to keeping prices moving higher for the next couple of years, it could help change this dynamic. If people believe that prices are going to rise in the future, they may be less cautious about spending in the present...
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