Financial Times; May 09, 2003
Why the Fed prays for higher inflation
By Alan Beattie
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But how big is the threat? The developments that sparked this sudden concern, though not immediately obvious, are discernible on close examination. True, increases in oil prices have driven headline consumer price inflation to 3 per cent. But that is no solution to deflation: an oil shock, by hitting profits and real wages, increases the chance of a sharp economic slowdown which will put further downward pressure on underlying inflation.
The Fed's favourite measure of inflation, the national accounts price index for personal consumption with volatile items stripped out, has dropped to 1.5 per cent year-on-year and an annualised rate of just 0.9 per cent in the first quarter of 2003. These recent developments put inflation close to the bottom of the 1-2 per cent band identified by Ben Bernanke, the increasingly influential governor appointed last year, as a safe range. Moreover, Reinhart warned that the personal consumption measure probably overstates true inflation by half a percentage point.
[Vincent Reinhart is a Fed senior staffer who acts as secretary to its open market committee, and was the first one they sent out to lecture on the subject in March.]
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Despite the fact that the US outpaced most other rich economies over the past year, the Organisation for Economic Co-operation and Development estimated that actual US gross domestic product was 1.5 per cent short of potential. This output gap was equal to Japan's, and well above the eurozone's 0.9 per cent. This year, the OECD predicts the US output gap to rise above 2 per cent.
Fortunately, as Mr Reinhart pointed out, the effect of output gaps on inflation in the US is estimated to be quite slow. One rule of thumb used by Wall Street economists suggests that each percentage point of output gap reduces inflation by a third of a percentage point.
But the effect accumulates over time as the economy continues to undershoot potential. If the output gap persists, US inflation, properly measured, could drop uncomfortably towards zero by the end of the year. If growth does not pick up, the Fed does not have a great deal of room for manoeuvre.
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Full article with charts: http://tinyurl.com/bmxy
Michael