Prices of oil, food, gold, copper, cotton, and many other commodities have soared in the past year, raising concerns that inflation could again become a major problem in the United States. Already, it has become a primary challenge for countries such as China, India, Russia, and Brazil. Central Banks in emerging markets have raised interest rates, reined in credit growth, and imposed price controls in some areas.
Industrialized countries are now also moving to counter rising prices. Last week, the European Central Bank took its first tightening step since 2008. It boosted its key lending rate by one-quarter of a percentage point to 1.25%. Canada and Australia had previously moved to tighten policy.
The United States and Japan remain outliers in the monetary policy arena, maintaining their stances of low interest rates and an abundant creation of credit. The aftermath of Japan’s earthquake and tsunami make monetary ease appropriate there but is it the right policy for the United States?
Labor costs are the principal driver of inflation in this country and those costs are still restrained. High unemployment is limiting the rise in wages while ongoing gains in productivity are offsetting a sizable amount of the increases that are taking place.
However, there is a considerable lag between changes in monetary policy and the impact on growth and inflation. Federal Reserve Board Chairman, Ben Bernanke, believes that the run-up in commodity prices will be temporary and that the inflation genie will stay in the bottle. Yet, there is a chance that the jumps in commodity prices will continue to feed into the prices of many goods and services and that inflationary expectations will rise.
The Federal Reserve’s aggressive program to purchase $600 billion of Treasury securities is likely to be completed at the end of June, as scheduled, and not renewed. It remains to be seen if the Fed will allow maturing securities to run off as they mature or if they will be reinvested as now is the case with maturing mortgage bonds. It is probable that the Fed will begin to begin to gradually shrink its balance sheet, which is now approaching $3 trillion, by first allowing run-offs and then actively selling off securities. Monetary authorities are also likely to begin raising interest rates by the end of this year, with a small quarter percentage point boost in the federal funds rate from its current zero reading.
The Fed’s “exit” strategy will be critical to the prospects for inflation, interest rates, and the dollar. Monetary policy has typically been late in both loosening and tightening in response to changing economic conditions. Hopefully, this time will be different.