The merits of inflation concerns are hotly debated on Wall Street. Global Insight economist Brian Bethune argues that inflationary threats are overstated due to soaring energy prices, which are driving up prices in other commodities markets, while major portions of the U.S. economy, like technology and autos, are actually showing signs of deflation.
For his part, Fed Chairman Ben Bernanke has acknowledged that inflation measures have been "elevated," but he's forecasting that those measures will moderate in the "coming quarters."
"Headline inflation has become uncomfortably high, and at this point, inflation expectations have moved forward at such a rate that it is clearly making the Fed very uncomfortable," says Joseph Brusuelas, chief U.S. economist with IDEAglobal. "Fisher and Plosser are making very persuasive cases that the Fed should not give away the store on inflation."
Hot Debate
Despite the shift in expectations, other economists point to the housing market's decline as evidence that the economy will not be rebounding in the second half of this year. Even as inflation concerns grow, they argue, the Fed will eventually be forced to continue lowering rates.
"[Fed officials] don't want to be remembered as the guys who went down failing to prevent the second Great Depression," says David Merkel, chief economist with Finacorp Securities and a contributor to
RealMoney.com. "That's the elephant in the back of their minds, which makes me think that inflation will go a bit higher before they finally say they have to go after it. It's a rotten situation, and Ben Bernanke is a bight guy, but he has been dealt a rotten hand."
In addition to promoting price stability, the Fed also has a mandate to promote full employment in the economy, and Merkel says this is being complicated by a process that he calls "debt deflation." Big banks like
Citigroup(C Quote - Cramer on C - Stock Picks),
Merrill Lynch(MER Quote - Cramer on MER - Stock Picks) and
Bank of America(BAC Quote - Cramer on BAC - Stock Picks) all have reported billions in fresh writedowns tied to bad mortgages and other credit.
"You have a huge amount of bad debts in the financial system that are not worth the face value of the paper that it was written on," says Merkel. "The Fed probably can't fix this problem, but it will try because it's so politically big. They're trying to prevent a downturn by throwing a lot of credit at the problem. The other alternative is to allow the debts to deflate and let the banking system come back with whatever healthy banks survive the shakeout, which probably amounts to another Great Depression scenario."
Given the Fed's options, Bank of America economist Mickey Levy doesn't think the central bank will be finished lowering rates after a quarter-point cut next week.
"The Fed is in a bind," says Levy. "But under historic circumstances like this, even though there are inflation pressures, they'll continue to lower rates."
Lehman Brothers economist Ethan Harris notes that investors got ahead of themselves in March, calling for a 100-basis-point rate cut from the Fed that became a disappointment when it was only 75.
"That was interpreted as a hawkish Fed not willing to supply what the market wanted," says Harris. "In fact, that was an extraordinarily aggressive move from the Fed. Now, everyone has run from one side of the ship to the other. They were expecting too much from the Fed, and now they're expecting much too little."
Harris points to the unsold inventory levels in the U.S. housing market as a sign that the foreclosure process has only just begun and the economic downturn is still in its infancy.
"The recession will kill the inflation problem," says Harris. "It's not unusual for inflation to pick up in the first half of a recession. It takes time for the problems in the economy to create unemployment and to cool of the commodity markets. Given how weak the economy is likely to be, it's only a matter of time before we start seeing friendlier inflation numbers."
Nat Worden
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