Why is the Fed So Indecisive About Inflation?

by: James Picerno

Maybe, just maybe, Fed Chairman Bernanke has no better handle on inflation's future than the rest of us.

Yes, Ben's a smart guy. To be precise, he's one of the most respected monetary economists in the country, if not the world. That's a big part of why he sits atop the world's most important central bank. But as Wednesday's testimony to Congress suggested , even the mighty feel inclined to bow to the vagaries of the future when it comes to setting monetary policy for the morrow by making decisions today.

We refer readers to Wednesday's news that core inflation continued to fall in June. By any reasonable standard, the trend should encourage the Fed, having professed for some time now that core measures of inflation are superior to headline measures for influencing monetary policy. But listening to Bernanke's testimony, we were struck by his tendency for hedging his comments about the prospects for keeping inflation contained.

At the heart of this hedging was the Fed chief's reference to rising headline inflation (which includes food and energy), at a time when core (which excludes those two items) is slipping. In his prepared remarks he admitted that:

Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months -both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability.

The operative phrase is "if maintained." The central bank has the power to contain inflation, or let it loose, we believe. A quarter century of Fed experience, and three Fed heads suggest no less. As a result, there are no ifs, ands, or buts, about it. If the Fed is determined to keep the inflation genie in the bottle, there's no reason to think that an enlightened hawkish monetary policy won't do the job.

It may not win Bernanke and company new friends, particularly in Congress. But monetary discipline, applied in a timely manner, will serve the economy and, more importantly, the American public. A central bank can provide no greater gift than price stability. What's more, the accumulated evidence over the past generation firmly supports that rosy view.

What then is there to argue about? Good question. Listening to Bernanke, however, one could be forgiven for thinking that central banking is a dark art, subject to strange phenomena that few can decipher, much less resolve.

He explained that "because monetary policy works with a lag, policymakers must focus on the economic outlook." Does this imply that monetary policy proper is too tough to handle directly and so the central bank must also seek pricing stability by trying to forecast the economy? If so, who among us believes that economic predictions are easier than deciding what constitutes sound monetary policy in the here and now? Or, to put it more bluntly, didn't Volcker, and Friedman teach us anything?

Yes, core inflation is behaving as the central bank prefers, Bernanke said. On the other hand, headline inflation is rising again. But long-term inflation expectations are "contained" he added. In addition, futures prices suggest that

investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets [are] likely to ease modestly [and so] core inflation should edge a bit lower, on net, over the remainder of this year and next year.

The bottom line: the Fed's official forecast for core inflation (as defined by the core rate of personal consumption expenditures), is 2.0% to 2.25% for all of 2007, slipping to 1.75% to 2.0% next year. Sounds good to us. What's more, the Fed has the power to engineer that outcome, assuming it maintains policy discipline and doesn't waver as the election cycle heats up.

Why then, is there all the hedging and hawing? Is inflation fighting still subject to variables beyond the central bank's control? Say it ain't so, Ben.