Spiking the Fed's punch bowl

 

William McChesney Martin, a former Federal Reserve chairman, famously observed that the job of the Federal Reserve was to take the punch bowl away just as the party got going. Judging by last Wednesday's press conference by current Fed Chair Janet Yellen, it would seem that she does not subscribe to her predecessor's wise adage. For despite the many clues to the contrary, she neither sees any risk of U.S. goods price inflation nor, perhaps more importantly, any risk of asset price inflation. And instead of removing the Fed's punch bowl, she chooses to continue with the policy of bloating the Federal Reserve's $4 trillion balance sheet by additional U.S. Treasury and mortgage bond purchases, albeit at a somewhat reduced pace.

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Yellen's dismissal of recent inflation data as just noise is disturbing especially considering the current domestic and global economic context. For that dismissal is being made at a time that the U.S. labor market gap continues to shrink and most U.S. inflation indicators point upward. Indeed, unemployment is now approaching 6 percent while consumer prices are now increasing by more than 2 percent, or above the Fed's implicit inflation target. Her remarks are also being made at a time that global geopolitical developments have pushed international oil prices to their highest level over the past year, which does not bode well for future inflation performance.

What makes Yellen's complacency about goods price inflation all the more difficult to understand is that it is occurring at the very time that rapidly unfolding geopolitical risks pose a major threat to global energy supply. One would have thought that Iraq's present descent into chaos has to raise questions about the security of oil supplies from a country that is the second largest OPEC producer and that was being counted on to meet a large part of the future increase in global energy demand. One would have also thought that any disruption in Iraqi oil supply would have been all the more unfortunate considering that it is occurring at a time that both Libya and Syria continue to experience oil supply difficulties and at a time that Russia's attempt to destabilize Ukraine poses a real threat to Russian natural gas supply to Europe.

Equally disturbing is Yellen's dismissal of any notion of U.S. or global asset price inflation, especially considering the Fed's past dismal record in detecting asset price bubbles. For that dismissal is occurring at the very time that all too many indicators are suggesting that markets are currently grossly underpricing risk. Among those indicators are the facts that market volatility is now close to its pre-2008 Lehman crisis low, high yield credit spreads are well below historical probabilities of default, equity valuations appear to be stretched, and European sovereign bond yields are at record low levels despite continuing increases in European public debt to GDP ratios.

Hopefully, in the coming weeks, Yellen will keep an open mind and pay the closest of attention to incoming economic and financial market data. Since if she proves to be as slow in responding to further signs of goods price and asset price inflation as was her predecessor, the U.S. and global economies could be in for the roughest of rides next year.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.