When is Inflation Dangerous

The goal of monetary policy is “to promote effectively the goals of maxi¬mum employment, stable prices, and moderate long-term interest rates.” Stable prices in the long run foster growth and stability, however in the short run there can be some friction between employment and price stability. The Feds reaction can become very difficult when there are supply side shocks, namely a rise in the price of oil or energy. Decisions can lead to a pro cyclical business cycle making troughs deeper in order to rectify the system. With CPI at 5 percent we are entering a stagflation environment where inflation and unemployment will rise together. This is an anomaly in economics that does not occur often. It occurs when the price of commodity with inelastic demand increases substantially over a short period of time. This is shown in PPI which is at 9.2 percent, alarmingly high for financial stability. The Dollar rose this past week because traders decided that the Fed acknowledged this was unacceptable and may raise rates in the future. Highly unlikely and a quarter point rate hike would not reign in inflation.
Inflation has been relatively mild for the past 20 years, so few understand the pain of paying 14 percent yearly for a mortgage. This is what Volker did to rectify inflation sparked by the oil shocks of the seventies. The Fed Chairman Miller did not raise rates because he was concerned with growth; luckily he stepped down after a year at the helm of the Fed. Volker was forced to overshoot inflation to convince the market that the Fed was serious about extinguishing inflation. Bernanke is walking a thin line and will be forced to deal with inflation soon. With PPI at 9.2 percent the consumer will begin to feel the spill over affects of business raising prices. Greenspan hinted that the inflation fighting benefits of globalization have run their course. In short Globalization in the future will not contribute to decreased inflationary expectations.
The U.S. with their high current account may be forced to import China’s inflation. Many on Capitol Hill are protesting China’s undervalued currency; however would an appreciated Yuan decrease the U.S. current account deficit. At first glance yes, however remember that China exports Barbie’s which tend to be inelastic because they are a small percentage of our budget. In short an appreciation of the Yuan would make the inflation worse, while narrowly rectifying the current account. What could the Fed do to fight inflation; first priority is to keep a lid on inflationary expectations. This is done by having a Hawkish reputation, which the Fed does not have. The dollars value reflects this dovish bias and imported goods have become more expensive as a result. Basically in order for inflation to recede domestically and internationally the Fed must raise rates, and the cure needs to be much more severe the longer we let inflation fester.