Federal Reserve's Timing

More than once has the U.S. Federal Reserve assured the world that it is able to keep inflation at bay. That despite its massive quantitative easing effort, it has the capability to drain the excess liquidity from the money supply once recovery is fully entrenched, thereby averting any inflationary risk.

As Bernanke said: ""We are confident that we have the necessary tools to implement that strategy when appropriate."

I think there are two key phrases in his statement: "necessary tools" and "when appropriate".

As demonstrated by Paul Volcker, the Fed's Chairman between 1979 and 1987, to slay the inflation dragon, you just have to strangle it hard and long enough while enduring any pains that it might inflict upon you in its last-breath struggle. At the time of his first appointment, the inflation rate was hovering at 13%. Volcker pushed the benchmark federal funds rate from 11% to as high as 20% - 7% above the inflation rate, and as a result inflation rate was lowered to around 3%. The casualty: the recession of the early 1980's.

So I do not doubt that Feds has the necessary tools to extinguish any inflationary flare-up. After all, as demonstrated by Volcker, the Fed can go few notches higher even if draining the liquidity it pumped in over the past 12 months proved not enough to contain the inflation genie. But I am rather skeptical on whether they will be applied "when appropriate". I am doubtful because:

1. It is much harder to discern the threat of inflationary onslaught. Because of cacophony of noises from employment data to assets (mainly housing and equity) prices to core and general inflation rates are pointing at different directions, the Fed will have a hard time picking up the right signal and act accordingly.

One of the reasons for the noises is because the Fed has become a quasi-political organization. Unlike ECB where price stability is its ultimate measurement of success, the Fed is charged with ensuring sustainable economic growth. And over the years, it can be observed that the Fed, with pressures exerted upon it by the politicians, are willing to amplify the decibel level of economic indicators such as unemployment rates, default rates for housing loans etc. Which leads me to the second and more important point;

2. Even if a clear sign of rapidly building inflationary pressures can be detected accurately, will the Fed, being also concerned about the overall immediate state of economy and watched over by the politicians, act decisively or will it stall in implementing the necessary tightenings?

Given the track records of the Fed over the past years, in particular its reaction to the past economic slowdowns in this decade, my prognosis remain unchanged; i.e. inflation will return while world economy continues to limp along. In other words, stagflation will rear its head after an absence of 3 decades.