Posted by Joseph Y. Calhoun, III

Yesterday’s post on how Bernanke views inflation is echoed in an editorial today at the WSJ:

Mr. Bernanke’s FOMC remarks that day are especially revealing about how he thinks about monetary policy. In particular, he dismisses any link between commodity price increases and future inflation. He cites a study by a Fed economist claiming to find little connection between “materials” prices and overall inflation. Yet the price of oil was already rising sharply at the time, and it would keep rising as the Fed maintained negative real interest rates for many more months. This was a bad mistake.

Rising gas and food prices didn’t show up in the Fed’s “core” inflation measurements, but they sure did wallop U.S. consumers this decade. It’s one reason Americans never felt great about the expansion. The soaring price of oil also contributed to the housing bubble by transferring wealth from U.S. consumers to oil exporters such as the Gulf States and Russia, which in turn recycled those petrodollars into U.S. Treasurys and mortgage-backed securities. By ignoring commodity prices, the Fed fueled the housing boom.

It’s also striking how dismissive Mr. Bernanke is of the declining dollar. We’d have thought the greenback’s value would be the Fed’s paramount concern, given its mandate to keep prices stable. Yet Mr. Bernanke declared that “large movements of the dollar against major currencies tend to translate into smaller movements against the U.S. trade-weighted basket of currencies and into still smaller effects on import prices because of imperfect pass-throughs.” Translation: Exchange-rate fluctuations aren’t the Fed’s problem, no matter how disruptive their effect on trade and capital flows.

Instead of following these actual prices, Mr. Bernanke’s main monetary policy guide is something called “the output gap.” This is the difference between actual GDP growth and the level of “potential output,” or how fast the economy can grow when it’s at full capacity. The problem with this guide is that it relies heavily on labor costs and the jobless rate. And because job creation tends to lag economic recovery, these signals tend to flash yellow long after price pressures or asset bubbles have begun to build.

All of this is relevant today because there is no evidence that Mr. Bernanke and his Fed colleagues have changed their thinking. They still ignore a falling dollar and rising commodity prices, even as oil has climbed to $70 a barrel from $40 six months ago. They also continue to be slaves to the output gap, which means they are unlikely even to begin to tighten as long as the jobless rate remains high. With that rate now at 9.4% and likely to rise, the monetary spigots will probably remain wide open for a long time to come.