Goldman Sachs: Morgan Stanley's inflation report is greatly exaggerated

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The inflation hawks never seem to give up. This time, though, a really big dove has overwhelmed a younger hawk.

Goldman Sachs (GS) is now arguing that as far as inflation goes, the U.S. Federal Reserve can take it easy, because there's no problem ahead. Morgan Stanley (MS), on the other hand, sees an inflation risk if the Fed sticks to its quantitative easing policy for too long.

Dueling scenarios

Through fiscal and monetary policy, the United States has added a record $12.8 trillion in stimulus to the economy and financial system, much of it quantitative easing by the Fed. That level of capital injection has spooked Joachim Fels, co-chief global economist for Morgan Stanley.
"The greater risk is they keep accommodation too long rather than tighten too quickly," Fels told Bloomberg News Tuesday. "The price they would then pay is higher inflation for keeping the economy afloat."

Ed McKelvey, U.S. economist for Goldman Sachs, says those concerns are exaggerated, and that public policy makers have time to deploy as many as 10 options for ending their more than $1.1 trillion in aid to the banking system without risking a sustained increase in consumer price inflation.

U.S. inflation: The facts (so far)

What does the official consumer price index data compiled by the U.S. Labor Department say about the intervention's impact on inflation at the retail level? So far, inflation remains tame.

As of May, consumer prices had fallen 1.3 percent in the past year – the largest decline in prices in the United States since 1950. Further, wage pressure is not existent. Inflation-adjusted weekly wages, also called real wages, fell 0.3 percent in May, and have increased just 2.8 percent in the past year.

At the same time, the lack of a decline in core prices suggests deflation is not taking hold.

Also, the PCE deflator – the Fed's preferred price gauge – rose 1.8 percent in the 12 months including May. That's within the Fed's so-called 'comfort zone' of 1.7-2.0 percent, according to the Fed's minutes from its April meeting.

Goldman Sachs argues the greater risk remains the deflation scenario, saying the Fed may have a harder time easing credit more, should the U.S. economy deteriorate, and not enter a Q3/Q4 recovery, as expected, Bloomberg News reported. In a July 1 research note, Goldman said it's "very unlikely" that the Fed will "lose control" of inflation and that the world's most powerful central bank should err on the "accommodative side" of monetary policy.

Economic Analysis: It remains to be seen whether the Fed's impressive record of containing inflation can be maintained in the new era of record intervention by the central bank. That's because, to cite a Bob Woodward phrase, "We're in uncharted waters." The Fed has successfully ended the liquidity crisis, but the credit crisis remains: credit availability remains inadequate. That fact, combined with only modest improvement in several economic fundamentals, points to the Fed's maintenance of its quantitative easing stance thru summer, and probably well into the fall. The danger in that policy is, of course, a jump in inflation as credit becomes more available. To be sure, there is a risk of rising inflation but the view from here argues, given asset and wealth destruction, and slack labor markets, the greater risk is with deflation stemming from a liquidity trap. Hence, the Fed's accommodationist stance is the correct policy, at least through the end of Q3.
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