Can the Fed Maintain Its Fight Against Inflation?

For the past year, the Fed has incessantly told us how imperative it was that its reputation as an inflation fighter remain intact, because its own studies had shown that increasing inflation expectations, by both Main Street and Wall Street, have ultimately led to higher actual inflation.

However, due to the recent credit meltdown, the Fed has been forced to choose between maintaining its reputation as an inflation fighter and its responsibility to keep the US economy from a systemic meltdown, and last week it made the right choice.

However, in the meantime, investors have learned to tune out the Fed's inflation warnings, which seemingly have become just meaningless rhetoric, and have instead bidded up long dated Treasury prices to record highs that have pushed the yield of benchmark Ten-Year Treasury Notes to 50-year lows.

The following is an excerpt from our September 16th Asbury Alert entitled August CPI Data: Headline Inflation Remains at Gulf War Extremes:

Headline consumer price inflation eased sharply in August on lower energy costs, but still came in exactly as the market expected at -0.1% for the month. For perspective, headline CPI rose by 0.8% in July.

However, the year-over-year change for August stayed essentially the same at 5.4% (from 5.5% in July) which, as our first chart shows, is its highest level since the 1990-1991 Gulf War. Aside from the Gulf War, you would have to go all the way back to August 1982 to find a higher YOY change than we had in August. One year ago, the YOY change in headline CPI was just 1.9%.

click to enlarge

Today's data show that both core and headline consumer inflation are holding in at their highest levels in the past 10-25 years, respectively. However, the ongoing meltdown in the US financial system is preventing the Fed from doing anything about it. All the Fed can hope for now is that the current weakness in the economy will take care of this growing inflation problem by itself, before it gets much worse.

Now that the US government has seemingly backstopped the systemic threat, or is at least making a serious attempt to do so, we think this recently-hot but ignored inflation data now becomes much more influential on future monetary policy.
 

Comments

[Steven Hansen:]

inflation is the least of our worries. the 5.4% rate was mostly triggered by the aftermath of energy issues, and my continue to rise short term. but the real risk is deflation as the economy contracts this time as there is a big shortage of liquidity.

2008 Sep 24 02:26 AM