- Headline inflation was higher than expected in 2010, but not at problematic levels.
- The Fed's re-evaluating QE2 in light of higher inflation and growth expectations.
- Given inflation remains benign, QE2 will likely be completed, but not extended.
- More Fed attention to inflation now should decrease the risk of monetary policy staying too loose, too long.
Friday brought a sizeable goodie bag of US economic data. Among the many treats were December industrial production handily beating expectations and retail sales reaching a new all-time high—final 2010 totals showing the economic expansion is progressing nicely.
Less obviously sweet were the inflation numbers. Consumer prices rose slightly more than expected in 2010—+1.5% for the year. Despite the slight uptick, headline inflation is still far from problematic. Those expecting spiraling deflation or hyperinflation in 2010 were both proven wrong.
Most of the recent rise came from higher energy prices. Core CPI (excluding food and energy) is especially benign, rising only 0.8% in 2010—the lowest calendar year reading since the metric was introduced in 1958.
Of course, what matters most isn't what just happened, but what happens from here. Wholesale inflation was up 1.1% in December, for a total 2010 increase of 4%. Some folks fear producers will soon pass higher input costs to consumers. Any material inflation increases are likely a way off though. Yes, capacity utilization reached its highest level since July 2008, but it's still well below long-term averages, so it's easy for firms to undercut others' prices. And unfortunately unemployment is still high, but competition for jobs caps prices in the labor market. Further, long-term US Treasury yields—arguably the best gauge of future inflation expectations—are still relatively low.
With that in mind, it's safe to assume the Fed isn't too fussed with short-term inflation risks. Members do expect modestly higher inflation in 2011, but their forecasted 1.5% – 2% inflation range isn't troubling. Fed members are meeting later this month to "re-evaluate" their QE2 plans. But expanding the Fed's balance sheet further isn't likely to stoke inflation as long as economic slack remains, so chances are the full $600 billion will still be spent.
However, the Fed ultra-loose monetary policy may begin to shift once QE2 is complete. Economic growth expectations are on the rise, and Fed members are becoming more vocal about future inflation concerns. Don't be shocked if the Fed's balance sheet begins shrinking before yearend, even if that means simply not reinvesting interest and principal payments.
We've said for a while the Fed's initial monetary accommodation was appropriate, but the exit plan would be key to the ultimate success or failure of the Fed's stimulus efforts—if they didn't rein in monetary policy appropriately, inflation could materialize and choke off growth. The increased focus on inflation reduces the chances of staying too loose for too long. Sure, unintended consequences are always possible, but for now a eye toward eventual tightening seems appropriate.