Business Outlook: The Danger in Tying the Fed's Hands

How much should we worry about inflation? In the coming year, nearly all economists say "not much." With so many workers and production facilities likely to remain idle next year, Econ 101 tells you the pressure on wages and prices is down. Looking beyond next year, though, the question is beginning to take on greater weight, especially amid recent congressional challenges to the Federal Reserve's authority and independence in conducting monetary policy.

The Fed's basic task is already herculean. Over the past year, excess reserves in the banking system, which determine the economy's money-creating potential, have soared to nearly $1 trillion, up from a comparatively trivial $2 billion or less before the financial crisis. Deciding when to start neutralizing this excess without either killing the recovery or breeding inflation will be hard enough. The Fed's increasing unpopularity on Capitol Hill adds another layer of difficulty. It may well have to begin tightening policy next year with unemployment at a very high level, something that would not go over well with such a hostile Congress.

More important, the Fed's credibility as an inflation fighter, which is crucial to its ability to make effective policy, may be at risk. Legislation coming out of the House Financial Services Committee, innocuously called the Federal Reserve Transparency Act and supported by two-thirds of the House of Representatives, would subject the Fed's decisions on monetary policy to congressional audit. That is, if Congress doesn't like the Fed's decision to hike rates amid high unemployment, it can forcefully and publicly challenge all members of the Fed's 12-person policy committee.

Any perception in the global financial markets that political pressure is influencing monetary policy would raise expectations of future U.S. inflation, which would push up interest rates and add downward pressure on the dollar. Rock-solid inflation-fighting credentials are the chief reason why the Fed has been able to run a wildly expansionary policy while keeping long-term interest rates low and avoiding a collapse in the dollar.

Concerns about inflation expectations, a crucial component of long-term rates, are central to the debate within the Fed over when to start tightening. The Fed's anti-inflation hawks are not thinking about inflation in 2010, but longer-term. They fear that an extended period of ultra-easy money could fuel the anticipation of rising prices. Such expectations can stoke actual inflation if they become deeply ingrained in business and consumer behavior.

Plus, the issue of underutilized labor and facilities is not cut and dried. Inflation hawks note that the jobless rate and operating rates can give misleading readings on the amount of slack in the economy, as happened in the 1970s. Technology and outsourcing may have rendered many skills obsolete, putting more upward pressure on the wages of workers with skills in need. And equipment is now wearing out faster than it is being replaced, thanks to sharp cutbacks in capital spending by businesses. That would imply a higher utilization rate that could create spot shortages and upward pressure on prices.

In fact, not all inflation measures are falling. Although core consumer inflation, which excludes energy and food, is declining in the broad services sector, goods inflation is running at the fastest pace in 16 years. For now, the markets perceive little inflation danger, partly out of their belief in the Fed's anti-inflation resolve.

That perception will be important, given Washington's need for $2.8 trillion in new money over the next three years, based on Congressional Budget Office projections. As San Francisco Fed President Janet Yellen noted recently, budget deficits don't typically cause inflation in advanced economies with independent central banks that pursue appropriate monetary policies. Right now, though, the Fed's independence and the appropriateness of its coming decisions are increasing uncertainties in the inflation outlook.

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