Fed minutes and worries about inflation, bubbles

The minutes released today from the Fed's meeting early this month made if very clear that Committee members are intent on keeping rates at rock-bottom levels for the foreseeable future. But policymakers are not operating in a vacuum and discussed risks related to the very loose monetary policy that has been in place for nearly a year.

Members are mindful that very low short-term rates could lead to "excessive risk-taking in financial markets or an unanchoring of inflation expectations."

Officials in both China and Japan have recently expressed concern that low interest rates in the U.S. could be fueling the carry trade - borrowing where rates are cheap and investing the proceeds in parts of the world that fetch higher returns - and speculative bubbles in Asia.

Although some members saw inflation risks leaning to the downside in the near term, others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits.

Moreover, these participants noted that banks might seek to appreciably reduce their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Either way, the money supply would surge.

Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation, the minutes said.

To keep inflation expectations anchored, all agreed it was important for policy to be responsive to changes in the economic outlook and for the Fed to continue to clearly communicate its ability and intent to begin "withdrawing monetary policy accommodation at the appropriate time and
pace."

In my view, a small rate hike would send a strong signal to the financial markets that the U.S. is serious about its commitment to a strong dollar and stable inflation, and it could help dampen the speculation in gold as well as curtail some of the commodity inflation we are seeing (see Rate hike: sooner rather than later?). However, a minor boost should have little negative impact on the fragile economic recovery.

With the unemployment rate now above 10% and poised to head higher, there is little likelihood that Fed will take that kind of bold action. Nonfarm payrolls, which showed no signs of stabilizing over the past three months (see Thoughts on unemployment), will need to begin evening out before the Fed signals it is in the twilight of its current policy.