·        February 28, 2012, 2:50 PM

Conditions Ripe for Inflation Inferno, St. Louis Fed Economist Warns

WSJ

By Michael S. Derby

New research from the Federal Reserve Bank of St. Louis warns there is more than enough kindling to start an inflation inferno.

The paper, written by staff economist Daniel Thornton, stands in opposition to the views of key central bank officials like Chairman Ben Bernanke and others, who argue that even as the Fed has pumped liquidity into the financial system, it has the tools it needs to control the inflationary potential of those actions.

In his paper, Thorton bases his warnings on the interaction between Fed liquidity actions and growth in the money supply. He acknowledges that in focusing on what happens with money supply, he is standing apart from the current view of many economists. Also, Thorton isn’t asserting the inflation environment has turned sour, only that central bank policy has created conditions for trouble, and that problems could develop quickly.

“Both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate,” Thornton writes.

He indicates current rates of inflation could suffer should money supply start to expand quickly: “The recent acceleration in the growth of the money supply is of particular concern because the year-over-year consumer price index inflation for December 2011 is 3.0% and the year-over-year personal consumption expenditures inflation for November is 2.5%, both of which are already above the [Federal Open Market Committee's] implicit inflation target of 2%.”

Thorton’s worry is rooted in the massive and ongoing liquidity the Fed has provided the economy since 2008. Much of that money actually hasn’t made it out into the economy, with banks parking the funds back at the Fed in the form of excess reserves.

These reserves “constitute an enormous potential to increase the money supply as the economy improves and banks’ opportunities to lend and invest improve,” the economist wrote. “The extent of this potential is demonstrated by the recent marked increase in the growth rate for total checkable deposits and required reserves.”

Thorton’s view is controversial. The standard line from most Fed officials these days is that even with the Fed’s balance sheet at a record $2.9 trillion, the power over interest rates on reserves nullifies the potential inflation threat. If those reserves look like they’re going to stampede out of the Fed’s corral and overheat the economy, the central bank can simply raise the interest rate it pays and draw the money back in.

But it’s an untested theory in the U.S. As long as the Fed finds itself in uncharted territories, it will continue to be dogged by fears that an extremely aggressive course of stimulus will ultimately result in something nobody wants: surging inflation.

·        January 27, 2012, 12:59 PM

Richmond Fed’s Lacker Explains His Dissent

WSJ

By Jeffrey Sparshott

U.S. Federal Reserve Bank of Richmond President Jeffrey Lacker, explaining an earlier dissent, on Friday said he doesn’t believe economic conditions are likely to warrant an exceptionally low federal funds rate through late 2014.

“I expect that as economic expansion continues, even if only at a moderate pace, the federal funds rate will need to rise in order to prevent the emergence of inflationary pressures,” Lacker said in a statement. “This increase in interest rates is likely to be necessary before late 2014.”

Fed officials Wednesday said they expect to keep short-term interest rates near zero for almost three more years and signaled they could restart a controversial bond-buying program in yet another campaign to rev up the disappointing economic recovery.

Lacker was the lone dissenter to the latest guidance on interest rates. His comments Friday offer a fuller explanation for his decision following a quiet period for officials.

The central bank’s pronouncement Wednesday came after a two-day policy meeting from which officials emerged still frustrated at the slow pace of growth and a bit more confident that inflation is settling down after climbing last year.

Officials hope that by signaling their intentions on short-term interest rates, long-term rates will fall, spurring investment, spending and growth. Since August, the Fed had been saying rates would stay near zero at least until mid-2013.

The Fed also offered for the first time forecasts by officials on interest rates alongside economic projections.

“The Summary of Economic Projections now contains detailed information on the forecasts of Federal Reserve governors and Reserve Bank presidents for the evolution of economic conditions and the federal funds rate under appropriate policy. My dissent also reflected the view that statements about the future path of interest rates are inherently forecasts and are therefore better addressed in the SEP than in the Committee’s policy statement,” Lacker said.