Producer Price Jolt

What was that about deflation again?

The Federal Reserve's Open Market Committee meets today, and right on time. Yesterday's producer price report showed that wholesale business prices rose 1.8% in November, or a 6.3% annual rate over the past three months and 2.4% over the past year.
The news hit markets with a jolt, because investors have become accustomed to the Fed's assurances that it must keep interest rates at their current historic lows for an "extended period" because the only real economic risk is deflation. Investors reacted by sending bond prices down sharply, as they wondered if the Fed may have missed its bet and will have to change course sooner than it has advertised.
Fed Chairman Ben Bernanke is notoriously stubborn, at least when he's easing money. And no doubt someone at the Fed will point out that if you remove food and energy from yesterday's report, then producer prices rose by only 0.5%. However, this is the same "core" price rationalization the Fed used earlier this decade to keep monetary policy too easy for too long. Deflation was another siren song that the Fed used in 2003 and 2004 to build the credit mania that led to the bubble, the blowoff and recession.
Like $1100 gold and $70 oil amid weak global energy demand, the producer price report is a warning that the Fed should already have begun to move back to a noncrisis monetary stance. This does not mean "tightening" in any normal definition of that word. Moving from near-zero rates to 1% would not be moving to a restrictive policy. It is the equivalent of slowing down from 200 miles per hour to 180 or 160. A more careful monetary policy will help the Fed's credibility and reduce the chances that the recovery is later cut short by an abrupt shift in policy.