Over at Economist's View: Tim Duy Hears the Keening of the Inflation Hawks at the Fed

Source: Tim Duy: http://economistsview.typepad.com/economistsview/images/duy61106.gif

Tim Duy is puzzled by the Fed. So am I. The inflation hawks appear to be ascendant, and, looking at unit labor costs as a leading indicator of the next six months' price numbers, it is very hard to figure out why.

Economist's View: Fed Watch: Ascendancy of the Hawks: Ascendancy of the Hawks, by Tim Duy: My time of capitulation has come. After the weak labor report, I would have thought a pause in at the next [FOMC] meeting a sure thing.... Since then, however, the din of Fedspeak has become deafening, and it speaks a single message--look for yet another Fed rate hike at the end of the month.... [T]he Fed promised us data dependency, and no one can argue they didn’t deliver, but, as I have argued in the past, they left out something critical: They simply failed to inform us about their underlying economic model. In other words, market participants were unable to grasp the implications of incoming data as far as it affected the Fed’s economic outlook....

[P]olicymakers... came out in force, with Moskow followed by Bernanke, Governor Bies, St. Louis Fed President William Poole, and Governor Kohn. The message: When we said data dependent, we didn’t mean all of the data, we meant just the inflation data. More seriously, David Altig succinctly summarized the message for us:

To paraphrase, yes we are pleased that the recent levels of measured inflation have not unmoored the public's belief in the FOMC's commitment to price stability. But yes, we also realize that the recent inflationary experience is not consistent with those beliefs--or the Committee's own objectives--and we do not take our credibility for granted.

In short, those of us drawn into the direction of a pause (see also Caroline Baum and John Berry) followed the increasing Fed chatter proclaiming the forecast for slower growth, assuming it was a signal from a new Fed Chairman known to be a proponent of inflation targeting.... The first mistake is that even if this was what Bernanke had intended, he does not have the political capital within the FOMC.... The second mistake is more fundamental: Barring clear evidence that the economy has rolled over, central bankers will always weigh incoming inflation data over all other data....

Note that three District Banks--Kansas City (Hoenig), Philadelphia, and New York--wanted to keep the discount rate steady last month.... New York’s interest in holding the discount rate steady is intriguing. Bank President Timothy Geithner’s position puts him in steady contact with global financial markets, and one wonders what he is hearing.... [I]n addition to the ECB, the central banks of Turkey, India, Korea, and South Africa all tightened. Global markets have swooned, and the yield curve in the US has slipped into inversion between the two year and the ten year Treasury rates. If the long end doesn’t starting selling off over the next few weeks, the Fed is setting itself up for a significant inversion....

An expectation that the Fed would not go too far may have been simply naïve. One contact simply noted with a sigh, “But they always go too far.” What will drive them to go too far? We can start making a list:

1. Fed officials on average will discount financial market signals... dismiss concerns about the yield curve.
2. Fed officials will discount the impact of the housing slowdown.
3. Talk of inflation targeting aside, Fed officials will place a high weight on current inflation numbers. Even if the numbers this week look tamer, the hawks will fixate on the last two months of data.
4. Fed officials will want clear signs in the data before they acknowledge that a slowdown is actually underway. It can take awhile for such data to build. Economists, me included, are prone to this error.

Do I sound somewhat pessimistic? I would rest easier if the economy didn’t look to be slowing, or if experience had not taught me to be wary of asset market (in this case housing) reversals. I would also feel better without the ascendancy of the hawks at the FOMC. Time will tell, but with growth moderating, I am not seeing the inflation threat. The slowdown in nonfarm payrolls eased my mind considerably--it seems unlikely that inflation will get out of hand without considerably higher nominal wage growth than we are seeing. Nor did the last reading on productivity suggest an inflationary surge is at hand...