Recent spikes in energy and food prices may have consumers digging deeper into their pockets but so far have not alarmed U.S. monetary policymakers. "The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation," the Federal Reserve said after the March 15 Federal Open Market Committee meeting. "The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations."
After leaving short-term U.S. interest rates near zero, where they have hovered since December 2008, the Fed also said the "economic recovery is on a firmer footing." So the question remains: At what point would the rise in prices either put a brake on the recovery and/or alarm the Fed enough to raise rates?
Part of the answer might lie in whether the source of the upward pressure on prices is tied to an increase in demand or a drop in supply. For instance, assume that before an increase in the price of energy, the economy was set to accelerate from 3% growth to 4% growth. Also assume that the price increase resulted from rising demand for energy. "If energy prices rise due to increased demand, the economy will not physically be able to increase its growth from 3 to 4%, which otherwise would have occurred," explained Paul Kasriel, Northern Trust's chief economist. But what happens to the economy if the price rise stems instead from a shift in supply? "If energy prices rise due to a supply interruption, the economy will not physically even be able to maintain its current 3% growth, much less accelerate to 4% growth," he added.
It is the latter issue — concerns about an interruption in crude oil supplies — that drove prices upward recently. That rise, coupled with worries about the pace of the recovery, has some observers fidgeting about a potentially related threat: stagflation. A throwback to the 1970s, stagflation can ensue when inflation climbs, economic growth stagnates and unemployment stays high.
In historical terms, however, current inflation is nowhere near the 10%-plus levels seen some 40 years ago when gasoline prices spiked. In particular, market expectations about inflation, a key indicator that the Fed factors into its monetary policy, appears to reflect ideas that inflation is not going to flare dangerously. "Inflation expectations have moved up since September 2010," said Asha Bangalore, senior vice president and economist at Northern Trust. "But the levels are within acceptable ranges and are close to readings seen prior to the onset of the financial crisis."
In fact, the spread between the five-year nominal Treasury note yield and the five-year inflation-protected security yield, which briefly widened on rising crude oil prices linked to geopolitical unrest in the Middle East and Northern Africa, has narrowed again, suggesting the market expects the Fed has room to keep rates low. "In terms of price indexes and inflation expectations, the Fed can justify the current easy monetary policy stand," Bangalore added.