Anatole Kaletsky Watch [2]

Note the centrality of 'inflation expectations', 'language', 'credibility' and 'market psychology' to the work of central bankers.

26 June 2006:

If the Fed manages to intimidate the markets, the US business community and the consumer with a really tough statement on Thursday, this shift in psychology may be enough to make another increase in interest rates unnecessary by August 8. What then would be the statistical requirements for the Fed to refrain from further tightening in August? The answer is simple: clear and unambiguous evidence of a slowdown in US economic growth. In order to end the tightening cycle, the Fed does not need to see inflation actually slowing, but it does need to get inflationary expectations firmly back under control.

From a strictly economic perspective, Ben Bernanke was probably right three months ago when he shook the financial markets with his hints of a pause in the Fed’s monetary tightening. As a theoretical economist he was perfectly justified in his prediction that the US economy would slow after roughly 18 months of monetary tightening and that inflation would decline after a further lag of 9 to 12 months. The problem was that while Professor Bernanke was right about the economics, he was totally wrong about market psychology. He should not have suggested a pause in the rate hikes at a time when the US economy still seemed to be booming, inflationary expectations and prices for gold, commodities and other inflation-linked assets were going through the roof.

But all that could change after Thursday, especially if the Fed accompanies its rate hike with some tough rthetoric. The key question will then be whether the Fed has done enough to stifle the speculative inflationary mentality that took over the markets in the first three months of this year. A pause by the Fed this week, as originally suggested by Professor Bernanke, would have been a big mistake, since it would have blown the Feds anti-inflationary credibility and created a bear market in all assets apart from commodities, gold and other inflation hedges.

By August the situation could be very different. As long as the US economy is clearly weakening by then, inflationary expectations will start to decline – provided only that the Fed can re-establish its credibility with some tough language.