Inflation or Deflation? The Fed and Market Expectations

Well, we are exactly one month from the announcement that inflation in the United States had reached a 17-year high of 5.6%. Now Paul Krugman is reporting that expected rate of inflation has fallen to the point where we may be talking about deflation. Granted, this chart is apparently based on core inflation which does not include oil & food - two of the main drivers of recent inflation - but oil has also retreated over recent weeks, easing some of the pressure.

This journal reported earlier that inflation was probably going to be a temporary, one-year hit, but this is a bit surprising. This development may also shore up Ben Bernanke's position against the inflation hawks* on the Fed Open Market Committee, who have been pushing for interest rate hikes for some time - hikes which would increase the cost of borrowing and dampen the rebound capacity of the American economy. In a nutshell, the hawks believe that the Fed's current low rate of interest is enough to fuel inflationary expectations; if Krugman's interpretation of bond rates is accurate, then the market disagrees. The Fed meets again on Tuesday so stay tuned for that.

Unfortunately, the specter of inflation is still haunting much of the rest of the world like that nearly-headless Harry Potter character. Instead of stimulating export growth, the plummeting pound sterling has so far only raised the prospective costs of imports for the UK. Meanwhile, the European Central Bank is also struggling with entrenched inflationary expectations as Germany's largest trade union is setting itself up for the largest pay hike in 16 years, to the tune of 7 or 8%. What higher inflation in Europe will mean for the rest of the global economy is something worth considering closely.

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*This post is the first of many appearances by Harold, the inflation hawk. His brother, Pete the deficit hawk, has been vacationing in the tropics for a while, with dire consequences.