Inflation expectations have now rebounded to the pre-financial crisis level of 2.0-3.0% in the interest rate futures market, consumer surveys and the spread of Treasury bill rates over inflation adjusted Treasury bills (TIPS). This is slightly above the FRB’s 2.0% target so the central bank is now pondering when it will need to tighten monetary policy.  Tightening will slow the pace of the recovery in the overall economy and in construction with higher credit costs. Tightening may seem premature when the bottom of the recession is still a few months ahead. But forces other than aggregate spending may be driving inflation in this cycle. And tightening moves take about nine months to be fully effective.

If the central bank believes that the higher inflation expectations and the subsequent rise in actual inflation results primarily from economic recovery, it can defer monetary tightening for at least a year.  There is an unusually large amount of slack in the economy evidenced by 9% unemployment, record low industrial capacity utilization below 70% and inflation currently near 0.0%, measured by the personal consumption expenditure deflator. The full impact of the tightening would not be a measurable restraint on spending until early 2011 at the soonest.

However, to the extent that the central bank believes that rising inflation expectations are due to cost pressures unrelated to an improving economy, the monetary tightening and resulting restraint on spending through higher credit costs will have to begin sooner to keep the rise in inflation below the threshold where it spills over in wages and sets off a wage-price spiral.

Setting the timing of monetary tightening will be a difficult decision for the FRB. Washington officeholders will pressure the Board to delay as long as possible.  They are always willing to trade future inflation for current votes.

However, the FRB is uniquely able to set the timing properly as it is at the source of the spending pressures unrelated to economic growth.  Now, these are the economic stimulus program funded by money created by the FRB and the Boards’ own surge in lending to pay for a variety of new lending programs to cover mortgage and other loan defaults.

The stimulus plan is not inflationary to the extent that it generates self-sustaining jobs and income. Similarly, the various new lending programs are not inflationary if the funds are repaid on standard commercial schedule. But it is increasingly clear that both the stimulus spending and the new lending programs have a substantial inflationary element.  For the stimulus plan, it is because the rules require higher costs that private buyers would pay and a large share of the funds are being used to simply fatten the bureaucracy.  For the lending programs, it is because the prospects of repayment on a standard commercial schedule are getting grimmer. This is true for both the $70B for the auto industry and the variety of government managed mortgage payment forgiveness programs.

The consequence is that the FRB may have to begin monetary tightening sooner than an improving economy would reequire to counter these political sources of inflation.  And the Board is known to be concerned that Congress and the President may soon add two new sources of inflation unrelated to an improving economy. These are the pending plans for the cap and trade electricity tax and the expansion of healthcare. While their sponsors claim that both will be good for the economy long term, they are clearly inflationary short term.  Money will be spent initially without producing anything that private consumers and businesses have shown any willingness to buy.

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