Tuesday, July 1, 2008

Hester: On Inflation Expectations

Hussman Funds: Anchored Inflation Expectations and the Expected Misery Index

William Hester on the Hussman Funds web site with an excellent article on one half of the Red's rocck and a hard place. Include a chart and a couple of excerpts but the whole article is good.

If inflation expectations have taken the prominent
role in guiding future inflation, some difficult policy situations
could arise. It is generally expected that more slack in the labor
force should ease inflation. But Bernanke and Mishkin have argued that
inflation has become less responsive to the unemployment gap, while
inflation expectations have grown in importance. That means it may be
more difficult to lower inflation and inflation expectations once they
become elevated. If inflation is less responsive to labor slack, more
slack – that is, higher unemployment - will be needed to lower
inflation (the measure of this tradeoff is often referred to as the
sacrifice ratio).

This means that delaying
convincing actions that would show that the Fed can contain price
levels would require a more severe response further down the road. A
credibly tough monetary policy would be a more manageable task if the
economy was recovering from a recession, instead of what looks like the
early stages of a contraction. Add in credit markets where
counter-party fear still dominates, an unemployment rate still rising,
and a presidential race looming, and the Fed seems to be left with few
effective responses

Bernanke and crew are between credit collapse and rising inflation the solutions appear incompatible. I prefer they deal with the dollar for the following reason: a weak economy due to credit contraction and the collapse of housing speculation is a painful 2 or3 year problem, but loss of control of future inflation expectations is at least a decade long problem.
Do a sudden coorddinated dollar intervention, send the message that is no longer going down. Make it worth investing in US assets again. It may hurt the economy more in the short term, but think of it as the quick sharp pain of a bikini waxing instead of the drawn torture of tweezers one follicle at a time.

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