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Even though inflation is low, monetary policy is inflationary

The CPI rose 0.5% in December, somewhat more than expected. Most of the rise was due to a big jump in gasoline prices. Ignoring energy prices, the CPI rose a mere 0.8% last year, and the headline CPI rose only 1.3%; that takes us all the way back to the very low and relatively stable inflation rates last seen in the early 1960s.

These tame statistics don't tell the whole story however. In the past six months, the CPI has increased at a 3.1% annualized rate. More importantly, the CPI ex-food and energy has been rising steadily (albeit at a bit less than 1% per year) for the past several years, even as energy prices have been soaring. If the Fed were pursuing a policy of price stability (which they are not, unfortunately), then a big rise in energy prices would necessarily result in a decline in non-energy prices, thus leaving the overall price level unchanged. But that's not happening. By being accommodative, the Fed is allowing higher energy prices to occur, without forcing other prices to decline. This is a recipe for more inflation.

If nothing else, this fact—that monetary policy is definitely accommodative—all but rules out the risk of deflation. As deflation risk fades into obscurity, markets are waking up to the fact that it's possible to raise prices and get away with it. Thus, nominal growth expectations are rising, inflation expectations are rising, and the combination is driving higher earnings expectations, thus lifting stock prices. Inflation and inflation expectations are still relatively tame, thank goodness, but this we are not in a stable, long-term equilibrium condition. Facts and expectations can change dynamically, but we don't know whether the Fed can adapt with sufficient speed and determination to changing conditions. This is no time to be lulled into a sense of low-inflation security.

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