When Fed Chairman Ben Bernanke delivered his economic outlook speech Thursday, the markets were disappointed because he didn't offer specific ideas for further monetary stimulus and stocks fell on the news.
But it would be unrealistic to expect him to offer specifics, as the Fed is divided on what – if any – further actions are appropriate. Some on the Fed are more concerned with inflation, while others are more concerned about economic growth and unemployment. Getting at least some degree of unanimity is essential before actual specifics are bandied about.
After all, with three dissents at the last meeting, anything that Bernanke might suggest speaking on his own accord might never come to pass. While Bernanke might not see a problem with inflation from further monetary policy moves – and quantitative models may back him up – that doesn't mean that further action won't be inflationary. The Fed is likely going to be cautious in its approach and members might be circumspect in their remarks.
No matter how the Fed – or any economist, for that matter – may try to quantify and model the effects of further monetary stimulus, a primary issue is that of expectations. Bernanke remarked that, right now, inflation due to rising food, fuel and certain other commodities has eased, and in some cases, reversed a bit, and that is helping keeping inflation under control for the time being. He makes a point that, so far at least, inflation expectations, particularly as detailed in the Thompson Reuters/University of Michigan Consumer Sentiment survey, are still relatively low and stable. This has helped keep inflation in some areas from being ingrained in the whole economy, as he noted.
Keeping those inflation expectations low and stable is vital to keeping actual inflation low. If the public expects inflation to be moderate, they will likely not demand higher wages, or accept higher prices or pass through higher input prices to customers. Businesses would be reluctant to raise prices because they expect their competitors to keep prices stable, as raising prices unilaterally may adversely affect sales and market share. On the other hand, should businesses expect rising inflation, they may be more willing raise their prices as they expect competitors to follow suit.
Workers may demand higher wages when it comes time to negotiate pay, either starting a new job or getting a raise at their current position, if they expect their costs of living to rise significantly. Consumers may also buy things now rather than later, should they expect prices to rise. This extra (albeit temporary) demand could also cause, or at least enable, businesses to raise their prices.
What the Fed needs to be especially vigilant about in embarking on further monetary stimulus measures is whether the public thinks those actions could spark inflation. The public already may see the Fed's actions to date as behind the surge in food, fuel and commodity prices, and may be a bit skittish about another larger-scale Fed intervention. With a significant, aggressive Fed action, the public's inflation expectations could become unmoored.
Research that demonstrates that much of the rise in input prices is due to demand from emerging markets (though some of it might relate to the Fed's actions). We may even quantitatively determine that the prior actions of the Fed were not behind this surge in inflation, but this is actually beside the point. It really doesn't matter a lick what is the real cause of rising food, fuel and other commodity prices. What matters is the fact that many people think that this inflation came about from quantitative easing and other programs.
Further Fed action could cause those people to come to expect additional measures to be inflationary and that alone may be sufficient to increase inflation, even with slack in the labor markets.
Now, the Fed is likely to carefully balance the risk and the (perhaps limited?) reward potential of further actions. While Bernanke's own views are that inflation is not likely to be a threat under current conditions, his approach to monetary policy tends to be driven by consensus of the other members of the FOMC.
There are enough hawks on the Fed that an ambitious monetary stimulus program might be watered down into something that could disappoint the markets, and it's even within the realm of possibility that the Fed might not even reach sufficient consensus to implement any significant further actions when it meets Sept. 20 and 21.
We need to keep our own expectations in check as to the size and scope – and potential knock-on effects – of what any Fed decisions might be.