Inflation & Central Bank concerns

Excellent article relaying comments made by Chicago Fed President Michael Moskow regarding Inflation and Central Bank Concerns.

The United States faces a risk that Asian central banks which are still hungry for U.S. assets will one day reach their limit and reinvest at home, Chicago Federal Reserve President Michael Moskow said Thursday.

For now, the U.S. economic outlook looks good, although inflation expectations bear watching, Moskow said in a question-and-answer session after a speech to the European Economics and Finance Seminar.

He said the Fed stands ready to act if necessary but that at the moment core U.S. inflation remains under control.

"We want to be very careful that inflation expectations do not increase," he said, terming price stability a "prerequisite to maximum sustainable growth."

Moskow's comments on inflation and the dangers of the big U.S. current account deficit roiled stock markets and triggered selling in U.S. Treasury debt markets.

The Fed's 7th District president, who is not a voting member of the rate-setting Federal Open Market Committee under this year's rotation, devoted much of his speech to long-term problems posed by the record U.S. current account gap.

In 2005, the shortfall in the U.S. current account -- the broadest measure of trade with the rest of the world -- reached $805 billion, or 6.4 percent of gross domestic product, a level some economists view as unsustainable.

"An economy the size of the United States cannot run large current account deficits indefinitely," Moskow said.

Eventually countries investing in the United States, such as China, Japan, developing East Asian nations and major oil exporters, "will reach their desired allocations of U.S. assets," he said.

"They're going to want to bring back and invest in their own countries," Moskow said, adding that the timing and pace of such a trend was hard to estimate.

Traders, who periodically fret about a messy unraveling of the current account gap that might send long-term U.S. interest rates soaring and trigger a steep fall in the dollar, keyed off this remark.

"He said at some point Asians will bring funds home, which wasn't very helpful ... One response may be the Fed having to raise interest rates to keep the dollar from collapsing as a result," said Michael Panzner, head of sales trading at Rabo Securities in New York.

A gradual contraction in the current account gap, which Moskow and many other Fed officials judged the most likely scenario, "probably would not have a major impact on U.S. price pressures or growth," he said, but added:

"There is the possibility, however remote, that current account imbalances could unwind in a more disruptive way."

Variables such as the current account deficit, the dollar or asset prices should not be targets of Fed policy, he said.

For now, Moskow said U.S. growth was self-sustaining, recent economic indicators were favorable and growth "rebounding smartly" from a weak fourth quarter.

On the eve of Friday's key U.S. March payrolls report, Moskow said it was tough to know how low the unemployment level could go without stirring inflation pressures, a reference to the non-accelerating inflation rate of unemployment, or NAIRU.

In the past a U.S. jobless rate of 5 percent has been associated with full employment, the level below which inflationary pressures can build. The rate has been below 5 percent for three months and March is forecast at 4.8 percent.

Moskow said a probable slowdown in U.S. housing markets "should be an important factor in bringing growth back to potential" as the Fed has forecast for 2006 and 2007.

But if housing remained solid "this would heighten the risk of above-trend GDP growth" and could be inflationary, he said.