This post appeared earlier today on RealMoney
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Federal Reserve has an opportunity today to get on top of the inflation problem today by showing resolve at a time that inflation pressures are diminishing somewhat. The Fed should deploy the strategy it loosely deployed in the 1990s by pursuing "opportunistic disinflation," a strategy designed to lower the inflation rate over time by taking advantage over decreases that occur in the inflation rate, particularly from recessions and drops in commodity prices or other price shocks (such as those from productivity booms).
With opportunistic disinflation, the Fed seeks to maintain the new, lower inflation that results from recessions and such by responding aggressively to any acceleration in inflation that occurs after inflation has been brought down. In the current situation, this means that the Fed can avoid raising rates and wait for the recession and other factors I mentioned to bring the inflation rate down, hence avoiding adding to strains in the economy and markets, and then move to calibrate the fed funds rate appropriately to maintain the new, lower inflation rate when it is attained. In this case, the Fed would eventually have to raise interest rates to assure that the newly attained inflation rate stays in place. The policy hence enables the Fed to pursue both short- and long-term goals, a perfect match for the current environment.
In the June 25 FOMC statement, the Fed said that although downside risks to the economy remained, they had "diminished somewhat." This is a statement that most believe must be modified in light of the many increases to risks that have surfaced since the statement. To mention a few: concerns about government-sponsored enterprises, continued financial strain generally, abysmal car sales, the increase in the unemployment rate and weakening global economic activity. At the same time, partly resulting from these factors, inflation risks have decreased. The recent decline in commodity prices is also reducing inflation risks, although the drop is too new to count on, one reason the Fed will probably not put too fine a point on it. Moreover, inflation expectations at the consumer level remain high, which requires continued vigilance.
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If the Fed is to be opportunistic and get ahead of the curve on inflation, it should acknowledge the recent increase in downside risks to growth but also maintain its vigilance on inflation. It is the best way to keep a good thing going -- the lowering of inflation risks. Later -- perhaps well into 2009, when the economy is on sounder footing and the inflation rate has moved lower -- the Fed can defend the new, lower inflation rate by raising the funds rate, hence achieving the next leg of its strategy of opportunistic disinflation.
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