MacroScope

Gabriel Debenedetti contributed to this post

Federal Reserve officials appear to be getting cold feet. Having just announced an open-ended bond buying program in September and then broadening it in December, minutes from last month’s policy meeting suggested an increasing caution about additional monetary stimulus among the Federal Open Market Committee’s core of voting members.

Several (members) thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.

That’s considerably quicker than investors had in mind. Stock and bond markets recoiled at the prospect.

Many analysts noted key figures like Chairman Ben Bernanke and his number two and potential successor Janet Yellen have often spoken out in favor of QE and argued Fed policy is having a positive effect. Says Eric Stein at Eaton Vance in Boston:

I still think the core of the FOMC will be very aggressive on the monetary easing side unless they are fully convinced that we are in a strong sustainable recovery or there is a significant pickup in inflation.

Are the world’s top central bankers too paranoid about inflation? As the United States struggles to sustain a weak recovery while the euro zone and Japan face outright contractions in output, a number of economists have called for the monetary authorities to be less dogmatic about adhering tightly to low inflation targets.

Most prominently, IMF chief economist Olivier Blanchard has argued the Federal Reserve’s 2 percent inflation target is too low given the severity of the loss of employment and growth that followed the Great Recession of 2008-2009. Kenneth Rogoff, co-author of an oft-cited study of economic downturns following financial crises called “This Time is Different,” has also championed greater inflation tolerance.

Fed officials, including Chairman Ben Bernanke, have flatly declined to entertain the notion, arguing that the potential cost – a loss of hard-won inflation-fighting credentials – is too high. “We are not seeking higher inflation, we do not want higher inflation and we’re not tolerating higher inflation,” he told a February hearing in Congress.

Updates with Fed decision

The Federal Reserve on Wednesday took the unprecedented step of tying its low rate policy directly to unemployment, saying it will keep rates near rock bottom until the jobless rate falls to 6.5 percent. That’s as long as inflation, the other key parameter of policy, does not exceed 2.5 percent.

Jan Hatzius, chief economist at Goldman Sachs, however, said in a research note published ahead of the decision that the shift may not be very effective.

Would such a move be a good idea? We’re not so sure. Calendar guidance may be theoretically flawed, but it is working reasonably well in practice. Fed officials have managed to keep expectations for the funds rate in the next few years pinned near zero, and the market now understands that this is more of a commitment to the promotion of future economic recovery than an expectation of future economic weakness.

A perfect storm may be gathering over India’s economy, brought on by a peak in inflation just as the country’s festive season, which is critical to consumer demand, gets under way.

Purse strings are loosened most in India during this season, which began with Navratri on Oct. 15 and will linger on with the festival of lights, Diwali, in a couple of weeks and culminate with Christmas.

Navratri, which roughly translates to “nine nights,” and Diwali shopping in India is as important to the country’s retailers and manufacturers as Thanksgiving and New Year holiday shopping is to those in the U.S.

High inflation is a drag on economic growth in the world’s second most populous country and matters immensely to over 400 million people, or over a third of India’s total population, who struggle to earn enough to feed their families three meals a day.

The particularly volatile nature of inflation in India has confounded policymakers and small business owners and has left economists, who are often running complex statistical models based on a dearth of reliable data, with a poor forecasting record.

To be fair, predicting economic data can be pretty tough in a country where collecting and reporting national statistics is still in its infancy stage. Provisional numbers are often completely revised away.

There appears to have been a significant slowdown in the second quarter. In particular we saw the pace of job creation slowed to a pace of 75,000 per month in the second quarter down from 226,000 in the first quarter and there are also concerns about slowing growth globally, beyond Europe but also in the emerging world and China, which was highlighted in the minutes (to the June meeting) this week. So, where do you think we’re headed? Are we just going to remain in a soft kind of pace? Are there upside risks to growth? Are there downside risks to growth?

Growth has definitely softened. The data are unmistakably weaker in the second quarter than we had hoped they would be. I think everyone recognized the first quarter and the end of last year were a little bit stronger than we might be able to sustain in the middle of the year but it’s definitely come in softer than I’d expected.

At the beginning of the year, it seemed as if Europe wouldn’t maybe weaken as much as we thought but lately the weakening from Europe has been coming online. In the U.S., I think we’re in a situation where we’re going to fluctuate from between the level where we are now to a level that’s more like we saw six or eight months ago. We’re going to have soggy patches, we’re going to have stronger spurts. If you look back over the last three years that’s the record you see. I don’t see a reason for that to change markedly.

It’s an arcane economics debate with all-too-real implications for U.S. monetary policy: Is high unemployment primarily the result of “structural” factors like skills mismatches and difficulties relocating, or is it largely due to insufficient consumer demand in a weak economic recovery?

The answer to that question may help determine how much further the Federal Reserve is willing to push its unconventional measures to bring down the jobless rate, currently stuck at 8.2 percent. If unemployment is cyclical, economists say, it would be more likely to respond to looser monetary conditions.

Research from Berkeley professor Jesse Rothstein, published earlier this year and featured recently on the National Bureau of Economic Research’s website, represents one of the most thorough academic efforts to date to discredit the structuralist version of events.

Another reason the Federal Reserve may have additional room for monetary easing: Inflation expectations fell sharply in May, according to the latest Thomson Reuters/University of Michigan survey of consumer sentiment. Inflation expectations five years out dropped to 2.7 percent in May, the lowest since January. Fed officials often say expectations are a key leading indicator of actual price increases.

Daniel Silver, economist at JP Morgan:

This level of longer-term inflation expectations is towards the bottom of the range that has been reported in recent years – 2.7% has been hit on several occasions (most recently between October 2011 and January 2012) and 2.6% was only reached back in December 2008 and March 2009, early on in the crisis period. Most other inflation measures that the Fed watches (including core PCE inflation and the 5yr-5yr breakeven inflation rate) have signaled that inflation expectations are still anchored and underlying inflation pressure is modest.

The downshift comes in the wake of inflation figures for April that also pointed to a tame price environment. This is why Eric Green at TD Securities argues “U.S. inflation favors the doves.”:

The Federal Reserve doesn’t get much love from Washington these days but it did receive a rare bit of political backing on Wednesday as Democrats defended its role in promoting full employment as well as stable prices.

The U.S. central bank has been the target of criticism from members of both political parties as a result of bank bailouts and hands-off rule-enforcement that let predatory and unsound lending practices go unchecked, among other shortfalls.

But discussing legislation narrowing the Fed’s mandate to a single-minded focus on price stability, Democrats questioned the need to drop the full employment side of the dual mandate.

Of all the questions Federal Reserve Chairman Ben Bernanke was asked during his press conference on Wednesday, one appeared to pique his interest in particular: Was he being less aggressive as central bank chairman than the advice he dished out to Japan as an academic in the 1990s would prescribe?

It was the second half of the question asked by Binyamin Applebaum and yet the chairman was eager to get right to it: “Let me tackle that second part first,” he began.

Applebaum may have been channeling the Nobel-winning economist Paul Krugman, a Princeton colleague of Bernanke’s and critic of Fed policy, who recently argued the Fed chief was being inconsistent and overly cautious.