The third issue is whether the rise in commodity prices will turn out to be persistent and, if so, how this might impact the inflation outlook. Recently, commodity prices have risen sharply. For example, the spot GSCI – a broad measure of commodity prices – has risen more than 35 percent over the past year. This was in train before the upheavals in the Middle East raised market concerns about potential disruption to oil supplies, pushing energy prices – though not other commodity prices – still higher. Commodity price pressures are pushing measures of headline inflation above measures of core inflation, which exclude food and energy prices. How worried should policymakers be about this development? Although there have been commodity price cycles in the past, commodity prices have not consistently increased relative to other prices, and indeed have declined in relative terms over the very long term. Historically, if commodity prices rose sharply in a given year, it has been reasonable to expect that these prices would stabilize or fall within a year or two. This property has been important because it has meant that measures of current “core” inflation, rather than current headline inflation, have been more reliable in predicting future headline inflation rates. In contrast, over the past decade, commodity prices generally have been on an upward trend. For example, as shown in Chart 25, fuel prices have generally been in a rising trend since 1999 and non-fuel prices since 2001 – both trends interrupted temporarily by the financial crisis.
In this way, the Federal Reserve can drive up the rate at which banks are willing to lend to more risky borrowers, restraining the demand for credit and preventing credit from growing sufficiently rapidly to fuel an inflationary spiral. For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding needed to achieve its dual mandate of full employment and price stability. If the demand for credit were to exceed what was appropriate, the Federal Reserve would raise the IOER rate – pushing up the federal funds rate and other short term rates – to tighten broader financial conditions and reduce demand. 2 If the demand for credit were insufficient to push the economy to full employment, then the Federal Reserve would reduce the IOER rate – pushing down the fed funds rate and other short term rates – to ease financial conditions and support demand, recognizing that the IOER rate cannot fall below zero. While the mechanism is different, the basic approach is very similar to the way the Federal Reserve has behaved historically. Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we have developed means of draining reserves to provide reassurance that we will not – under any circumstance – lose control of monetary policy.