An Inflation Experiment

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 |  Includes: FXE, UDN, UUP
by: Tom Lindmark

One of the excuses that economists advance for being so frequently wrong about most things is that theirs is a science which precludes testing hypothesis. In other words there isn’t any way to set up an economy and see if your theories are valid in the real world. Well, we may have an opportunity to see whether the ECB or the Fed knows what they are doing in managing inflation.

An article at the WSJ Real Time Economics blog points out that both countries are experiencing pretty much identical inflation rates — 2.7% with vastly different responses from their central banks.

Yet given the same set of inflation dynamics, the European Central Bank has already raised interest rates once and, based on Friday’s report, is likely to do so again as early as June. The Federal Reserve, in contrast, continues to pump money into the economy via QE2, and isn’t expected to lift interest rates from near zero for many months.

In large part, it’s a difference of emphasis. Fed officials think higher commodity prices are temporary, and that core inflation is a better gauge of underlying price trends. ECB officials target headline inflation, and worry that higher energy and food prices will filter through the economy via “second round” effects, namely higher wages and retail prices.

It’s probably not a perfect experiment as there are differences between the EU and the US as well as different mandates for each bank. Nevertheless, it probably is going to provide over time an interesting test of competing philosophies.

Of course, regardless of the outcome economists will conjure up all sorts of reasons why the results mean nothing.