Phillie Fed President Warns on Inflation

WSJ's Mary Anastasia O'Grady has an important interview with the president of the Federal Reserve Bank of Philadelphia, Charlie Plosser. In the interview, Plosser outlines some of the very real problems that face the Fed.

Plosser is clearly not in the Bernanke/Krugman camp who somehow view (viewed?) deflation as a concern:

Mr. Plosser doesn't see a deflation risk for the U.S. economy right now. Even those who were worried about deflation six months ago, he says, have begun to change their tune.

Next Plosser clearly shows that he had major concerns about implementing QE2, but, amazingly,went along with the power structure, as people tend to do in Washington D.C., and voted in favor of it.

Mr. Plosser reminds me that when QE2 was first proposed last year, he wasn't in favor. "I didn't think it was necessary and I thought that the costs outweighed the benefits." He says he thought that "it carried some very significant risks" that "would not be borne today but would be borne down the road when the time comes to unwind what we've been doing."

So why did he vote in favor of it? His explanation is nothing short of babbling:

But last month, when Mr. Plosser got his first chance to vote on the FOMC, he didn't dissent. When I ask why, he launches into a summary of his four principles of good policy-making: "clear communication of objectives," "credible commitments toward achieving those objectives," "transparency" and "independence."

What any of the above, especially "transparency" and "independence",  have to do with voting in favor of QE2, I have no idea. What it really comes down to is that these guys just don't have the balls to buck the power structure.

 Plosser also knows price inflation is coming (my emphasis):

Mr. Plosser says he likes to look at surveys, one of which, the Philadelphia Fed's "business outlook survey," is particularly "interesting" right now. The survey asks manufacturers about the prices they pay for their inputs and the prices they charge for their products. Businesses often feel, Mr. Plosser points out, that they are getting squeezed on inputs and yet can't raise prices. But over the last three months, the survey indicator has gone from "negative in November, minus-3, to plus-3 in December, [and then] to plus-17." In other words, "manufacturers are beginning to raise their prices."

Then, Plosser correctly warns about the trillion plus in excess reserves that could come flying into the system at anytime:

Those reserves are another signal that Mr. Plosser is watching closely. "We have all these excess reserves sitting in the banking system, a trillion-plus excess reserves," he says. This is money that banks choose to hold rather than lend out. "As long as [the excess reserves] are just sitting there, they are only the fuel for inflation, they are not actually causing inflation. But they could, because when banks convert those excess reserves into loans . . . we could see a very rapid increase in liquidity," he says. "That would be a very important signal, to me, that we are going to have to start reining in those excess reserves. Otherwise, if they flow out too rapidly, we will potentially face some serious inflationary pressures.

Plosser also knows that if those excess reserves start hitting the system, the Fed is going to have to raise rates real fast, to stop the flow out of excess reserves:

We could sell assets," he says, and thereby take dollars out of circulation. But that too sounds risky. "It depends on how rapidly rates go up and how rapidly we have to sell [the bonds]." He points out that selling them before rates go up would allow the Fed to avoid capital losses. That's because when interest rates go up, bond prices go down.
Could selling assets also stifle the recovery? Mr. Plosser says it might work out fine, but it might not. Dumping all those securities on the market would push bond prices down and interest rates up. "Suppose then the political hue and cry comes up and says 'Oh, you can't do that, you're disrupting the housing market, you're driving mortgage rates up.'"

In other words, the Fed would feel political heat for not letting the good times roll. "So then the Fed is faced with a situation whether it's either going to fight that political battle and say 'We don't care, we have to do this.' Or it's going to tolerate  more inflation" by refusing to act.

(One technical note: The Fed really doesn't have to sell assets, it could just raise the rate high enough, that it pays on excess reserves, to induce bankers to maintain the funds in excess reserves. This action by the Fed would have the same rate raising impact throughout the system as would asset sales.)

The Fed is in a nightmare situation. We are on the edge of huge price inflation. Yet, if the Fed stops printing it will crash the entire economy again. At the same time, because of Bernanke's new tool (paying interest on excess reserves), there is a trillion dollars plus, sitting on the sidelines that no one has any idea as to when it will come out, or how quickly.
Bottom line: There is no way we get out of 2011 without some major, I mean huge volatility in the economy. A huge inflation wave appears pretty much already baked into the system, but if the Fed slams on the brakes, a huge crash can not be ruled out either.