United States: inflation risk

The Federal Reserve is not ready to lower its guard on inflation and regards the market’s outlook for the economy next year as overly sanguine. Members of the Open Market Committee, which sets short-term rates, have repeatedly emphasised that the Fed’s bias is currently towards further tightening. Fed Governor Kevin Warsh said last month that inflation “remains elevated” and that it was “surprising” that the market was not more cognisant of the continued upside risk.

Fed Chairman Ben Bernanke echoed these comments when he warned that the tight labour market could force up wages and prices. Yet the central bank does not want to raise short-term rates, which could precipitate a housing collapse and recession. Instead, it has attempted to ‘talk up’ long term rates through its public statements, with little success: the bond market still expects the Fed to cut short-term rates 50 basis points by mid-2007. The Fed’s next statement, following its December 12 meeting, will again challenge this view.