Here is the key inflation issue: the Fed know core CPI is flat or falling and that the price of everything a person actually needs to live is rising rapidly (food, energy, healthcare, education, insurance, etc.). Plus, they believe the disinflationary effects of emerging markets has diminished which is evident from the fact that Indian firms are not outsourcing to Mexico where wages are cheaper (as one example). So, there is now an important (but quiet) debate in the FOMC and among the staff about whether more attention ought to be paid to headline inflation as well as core.

Plus, digging a bit deeper, they fear that real interest rates may already be negative if you adjust your numbers using headline instead of core. Or, even worse, you could think about using the inflation numbers that arise from the old methodology before they stripped everything out of it. That calculation (see John Williams' work on Shadow Statistics) shows inflation running at 8-10%.

So, there is much more worry than the market realizes about cutting rates now and essentially pulling the ripcord that unleashes an inflation which will be hard to deal with later (a la Greenspan's comments over the last few days).

George Zachar adds:

It is comforting to know that, under the surface, there are folks in the monetary clerisy that "get it" vis a vis honest-to-G-d inflation.

Unfortunately, the Fed's calculus is complicated by political and systemic risk factors. The left controls the political and media agendas, creating a fierce headwind against discipline.

And there's something about bank runs (albeit in the UK) that's apt to focus a central banker's attention on immediate problems, leaving longer-tailed inflation concerns for another day.

Greenspan publicized the notion that the Fed would try to make its mistakes in ways that could be remedied — that is, if they were going to screw up, they would do so in a way that left them policy tools to address the problem.

In the case of deflation, they deliberately stayed too easy too long, to make sure they didn't have "a Japan problem", assuming they could always jack rates up to mitigate subsequent inflation.

I fear/suspect that a similar calculation is being make now: Is it better to extinguish the systemic risk fire now with a big ease, and then later have to tighten even more? Or to make a half-effort now on the liquidity side, hope that's adequate, and promise to ease more if required?


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