Tuesday, June 10, 2008

Bernanke speaks ... The New Maestro

The dollar rose to the highest levels in three months based on comments from Fed Chairman Bernanke about how the Fed will "strongly resist an erosion of longer-term inflation expectations" . Translation, the Fed will fight inflation. Bernanke talks and markets move. It seems like we are back in a Greenspan era of markets getting jittery and reacting to every pronouncement.

Bernanke was actually giving a speech at the Fed of Boston's 52nd annual economic conference. For the text of the speech, see, "Outstanding Issues in the Analysis of Inflation". http://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm

The speech was very insightful on a number of fronts and not really associated with the comments that were reported in the newspaper. Bernanke first discusses commodity prices and inflation and notes that the forecast of prices through futures markets have not been very good and that the link between commodity prices and inflation is not usually strong. The issue of what futures are telling us about inflation is unclear. The latest poor predictions concerning the run-up in prices has exacerbated the problem. Unanticipated price changes will have real effects.
The speech also discusses the issue of labor costs in the inflation process. Wages are where we have not seen a significant increase in the US. Some emerging markets are seeing a wage price spiral, but to date the labor pipeline costs have not exacerbated with the commodity price increases. Th link between prices, labor costs and product mark-ups is no clear and this is the area where inflation will have the biggest potential effect.

Even if we can find the links in the economy, there is the additional problem of measurement in real time of inflation. If we can not measure inflation in real time there is limited policy responses that can be implemented in the short-run. We do not want to end up with the 1970's problem of driving in the rear view mirror of what happened in the past. when the world is changing quickly.

Of course, perhaps the most important issue is the formation of inflationary expectations. The process of learning, internalizing and acting on inflation is still unclear. Bernanke notes that recent survey research suggests that there is little clarity on how inflationary expectations are actually converted to price increases.

While we have learned a lot since the 1970's on the inflationary process, the problem is that we still have uncertainty on what is the process of how price shocks move to inflation and what can be done about it. This is a sobering testimony of what we do not know and what we have to learn to makes good investments decisions during a period of rising prices.




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