One dissenting FedRes member sees inflation becoming a problem

MarketWatch reports that non-voting FedRes member, Charles Plosser, dissents with fellow FedRes members and thinks that inflation will be a threat. He suggests that the FedRes should start raising rates sooner rather than later.

Plosser's dissent from the mainstream view is based on a fundamental disagreement about the sources of inflation. In the mainstream view, inflationary pressures cannot build up when the economy has so many slack resources. With unemployment so high and so many factories, machines, stores and offices sitting idle, no one company could gain pricing power because its competitors could easily ramp up output to meet any surprise increase in demand that could lead to higher prices.

The nonpartisan Congressional Budget Office has estimated that the output gap -- the difference between what the economy is producing and what it could produce -- will be a massive 7% of gross domestic product in 2009 and in 2010, and that the output gap will not close until 2013.


But Plosser said the official story is flawed in two ways. First, the output gap is almost impossible to estimate accurately, and is probably much smaller than assumed. The economy is undergoing a massive structural change due to the shock of the housing and credit bubbles, he commented. Resources are flowing out of the housing and financial sectors. Those resources cannot be easily redeployed in other sectors.

In effect, the output-gap calculations presume the economy can produce as much as it did during the bubble, he said.

"The output gap is not likely to be as big as standard estimates suggest," Plosser added. "If so, the economy may be at greater risk of inflation than the conventional wisdom indicates."

Second, the Philly Fed president said the output gap model of inflation just doesn't work empirically.

We should be "highly suspicious of inflation forecasts that depend heavily on measures of 'gaps' and 'slack,'" according to Plosser. "Instead, if we look at inflation forecasts from a model that runs solely off historical correlations in the data and incorporates forward-looking expectations, we find inflation rising significantly over the forecast horizon."

In fact, Plosser's own economic model has inflation rising above 3% in 2010 and 4% in 2012 if the Fed doesn't act. Even if the Fed does act, Plosser sees inflation hitting 2.5% in 2011, significantly above its target.

The majority of the FOMC said the inflation rate in 2011 would be between 1% and 1.9%.

Quite a number of investors, with David Einhorn and John Paulson among them, are betting heavily on inflation by loading up on gold or gold stocks.


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  2. The primary cause of the growing income inequality is inflation a dollar today is worth only one eighth what it was worth fifty years ago. Wages for many workers rise at a lower rate than prices increase thats the problem. We need a sound money policy and that means zero inflation. Just think of what will happen if inflation reaches double digits. Wages might increase only by 5% but prices could increase 10% a year. It won't be long before this leads to social unrest.


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