Summary
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Some forecasters believe the Fed could delay hiking rates until 2012. We beg to differ.
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The latest recession has been unusual compared with previous episodes. Several elements stand out: the contraction in capacity, exceptionally stimulative interest rate levels, quantitative easing, and massive fiscal stimulus at home and abroad. As a result, special attention should be paid to inflation.
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It is very surprising to note how buoyant core CPI has remained after 19 months of recession and with the Congressional Budget Office’s output gap estimated at -6%.
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In the past two recessions, import prices have been a source of headline disinflation. However, unlike what happened in the recovery period of 2002-2003, import prices are rising steeply now.
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Core goods inflation, which had typically been viewed as a source of disinflation in the past decade, has surged in recent months and is leading the upturn in core CPI. This stands in sharp contrast with the core goods inflation trend observed after the 2001 recession.
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Though we do not expect inflation to escalate out of control, it would be wise to be forward looking and keep inflation expectations in check. The current environment no longer warrants zero-percent interest rates to allow the economy to grow and labour conditions to improve.
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We continue to expect the FOMC to begin normalizing interest rates at its August 2010 meeting.
