Financial Watch

Earlier this week, Federal Reserve Chairman Ben Bernanke made some critical remarks about the recent direction in inflationary pressures. Prior to his statements many in the market expected last Friday’s disastrous employment report showing only 75,000 jobs were created in May would open the door to a pause for the Fed. Expectations going into Monday showed a 50/50 chance that the Fed would raise another 25 basis points later this month. Bernanke’s remarks led to some ugly selling on Wall Street and have started to raise some serious concerns whether the Fed may over tighten and cause a recession. What is most puzzling the Fed governor’s comments is that it erased the flexibility that had been built into the markets for the Federal Reserve to pause should economic data continue to paint a picture of slower growth. May’s employment report capped off a busy week of economic reports that offered evidence the U.S. economy had hit a soft patch last month and faces stronger headwinds in the coming months.

Bernanke has made public his expectations for core consumer prices to rise at an annual level between one and two percent. Other Fed officials have come out in support of Bernanke’s target for keeping inflation under two percent. Markets often focus on core prices due to the volatile nature of food and energy prices. Strong evidence has accumulated over time supporting the theory that the economy flourishes during periods of relative price stability. However, Bernanke’s target appears to fail to fully account for underlying inflationary pressures. The tech boom during the late 1990s and recession that followed are the only times since the 1960s that core inflation remained within Bernanke’s desired range. The currency crisis that rocked Asia during the 1990s caused demand to collapse abroad. Asia’s currency crisis forced the dollar to skyrocket, which caused foreign goods to become cheaper to Americans. Further, a rapid decline in demand among Asian consumers caused there to be excess capacity on the world markets. It is not surprising economic turmoil abroad pushed down inflation in the United States. Our second demand of price stability immediately followed the recession brought on by the collapse in tech. Once again excess capacity prevented prices from rising.

It is concerning to see the Federal Reserve has just about declared war on inflation when in historical perspective it is at very healthy levels for our economy. Concerns about inflationary pressures are presently far overblown. Outside of gas prices, there only limited areas where prices are noticeably increasing. We find this to be very impressive considering the U.S. dollar has depreciated sharply this decade. The global economy is moving along quite impressively and for the foreseeable future we should expect to see core inflation remain well-behaved, however barring frequent economic turmoil it will be nearly impossible for Bernanke’s Federal Reserve to maintain core inflation at a level he finds acceptable.