Inflation: The Fed’s Fault?

There is no point in my wading in too deeply on this topic. Many of you have asked whether commodity prices are not a sure sign of impending inflation, and whether this implies the Fed’s expansionary attempts are ill advised.

Yes. And no. Sort of.

That commodity prices are rising is undoubtedly a source of pressure on production costs, and thus, potentially, on prices. Please note the word ‘potentially’. There is not a direct one for one relationship between rising material costs and rising prices. This is because producers have to take into consideration the impact of demand and supply conditions in the end markets. If there is sufficient slack in those markets then it behooves producers to absorb some, if not all, the run up in commodity prices, as a loss in profit. This may be only temporary as demand conditions change, but it can soften the blow of commodity price increases.

We must also recognize the source of commodity price increases. Setting aside manipulation, for which, outside of the copper market, there is little or no evidence, the current rise in world prices seems to derive solely from growth. That is to say pressure is stemming from an inadequate supply with respect to current demand. Duh.

This is starkly different from the supposed inflation said to be imminent from the Fed’s expansionary activities. That inflation is nonexistent and very much the figment of the imagination of ideologically motivated commentators who seek to discredit the Fed and all government attempts to stimulate growth.

Given that our economy is still operating well below capacity, as it is, then the Fed flooding in more cash will not show up as inflation but as, hopefully, an expansion of activity. It will help push us back towards that capacity constraint at which point fears of inflation could become legitimate. This is one reason why I recently discussed capacity utilization as factor to monitor.

We are not at that limit yet, and will likely not be there any time in 2011. Don’t forget that unemployment is another component of the overall capacity picture, and no one expects labor to become a constraint on growth any time soon.

Thus, any signs of US inflation in the near term, and there are none right now, will come from growth in the world beyond the US economy, and not from the effects of policy actions by the Fed or the US government.