St. Louis Fed economist Kevin Kliesen opens the unmentionable Pandora's box of what happens if all the Fed's actions to date have been, gasp, flawed, and while containing the fallout of the financial crisis, the Fed may have well started on a new, and more dangerous path of a "destabilizing" liquidity driven inflationary explosion. Of course, to inflationists everywhere, this is a given. Deflationists may need some more convincing.

Foremost among the concerns of many is how to design a strategy that does not on the one hand raise interest rates prematurely, thereby prematurely nipping the economic recovery in the bud, while on the other hand does not keep rates too low for too long, thereby creating conditions that lead to a surge in inflation or inflation expectations. What’s needed is an effective policy to prevent the unprecedented monetary stimulus from becoming a destabilizing influence on price stability. Another key is accurately predicting inflation over the next few years.

More from Kliesen:

Some analysts believe that inflation will remain low as long as the unemployment rate stays well above its natural rate of unemployment (a measure of slack). Others, by contrast, believe that the risk of higher inflation has risen sharply because of the Fed’s large-scale asset purchase program and the advent of large, and possibly protracted, budget deficits.

In Figure 1, the path of the FOMC’s federal funds interest rate target is plotted along with the monetary base. The monetary base, which is sometimes called “high-powered money,” can be thought of as the raw material for creating money. Since both series are denominated differently, the chart indexes the series to be 1.0 in January 2007. The chart also includes vertical lines at August 2007, March 2008 and September 2008, when key events occurred in the financial crises. A considerable amount of disagreement seems to exist among economists about the inflation outlook over the next few years. Some economists are quite worried about the potential for much higher inflation, while others are more concerned about the potential risk of inflation falling to uncomfortably low levels—or even the possibility of deflation (a fall in the aggregate price level). Much of this disagreement reflects, on the one hand, the Federal Reserve’s aggressive response to the deep recession, the financial crisis and the exceptionally large federal budget deficits, and on the other hand, the downward pressure on wages and prices that typically occurs in the aftermath of a deep recession. Figure 2 depicts one way to gauge this disagreement. In Figure 2, the history of the Blue Chip forecasts of the average Consumer Price Index (CPI) inflation rate over the next five years is presented. The chart shows the average of the least optimistic inflation forecasts and the most optimistic inflation forecasts, as well as their difference (disagreement). During periods when inflation tends to be relatively high and variable, such as the late-1980s and early 1990s, there tend to be some sizable differences among forecasters about the medium-term inflation outlook. By contrast, during periods when inflation tends to be relatively low and stable, such as the mid-1990s to mid-2000s, forecasters tend to disagree less about the inflation outlook. Since early 2007, though, the level of inflation disagreement among forecasters has increased.

Indeed, and not only increased but is now at 20 year highs.

Yet possibly the most relevant topic in the paper is the discussion of the output gap. Zero Hedge previously presented thoughts from the St. Louis Fed, in "Why the" output gap" inflation model may be fatally flawed" which speculated that due to the bubble nature of the economy the excess slack as perceived by Bernanke may be completely irrelvant. It is notable that the it is the same regional Fed that created the underlying paper in that post. Could the St. Louis Fed be the biggest opponent to Bernanke's favorite metric of determining inflationary capacity in the economy? These two papers sure highlight that.

It is highly likely that this recession will induce considerable structural change in the economy. Indeed, this development already appears to be in train since many economic resources—labor and capital—that were employed in the automotive, housing and financial industries will need to migrate to industries that offer higher rates of return. One way to gauge the evolving structural change is by viewing the percentage of the labor force that is often characterized as the long-term unemployed (persons unemployed for 27 weeks or longer). As of November 2009, this percentage had risen to 3.8 percent, its highest rate in the post-World War II period.

Those who believe that the Phillips Curve framework can adequately capture the evolution of the inflation outlook over the near term must adequately account for structural changes that might have occurred in the boom and bust in asset prices. In its 2009 Annual Report, the Bank for International Settlements discussed these “bubbleinduced distortions” to current estimates of trend output growth and, hence, potential real GDP. Thus, it is conceivable that estimates of potential real GDP at the start of the recession were too large and that the structural adjustments noted above may have subsequently reduced potential real GDP from its artificially high level.

While it is probably unlikely that the fall in actual real GDP during the recession has been matched by the fall in potential real GDP, the size of the output gap might be smaller than conventional wisdom might believe. If so, those who foresee little risk to the near-term inflation outlook because of a large, persistent output gap may be too optimistic.

To borrow a Bushism, make no mistake: the last sentence is squarely directed at the Chairman, and reading between the lines indicates that the St. Louis Fed has become significantly more of an inflation hawk than previously expected.

The cautionary observations from Kliesen:

Policy is extraordinarily accommodative (see Figure 1), and the FOMC has said that “economic conditions

are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Although low interest rates are a key part of the FOMC’s strategy to boost economic growth and cement the health of the economic recovery, there might still be a danger of inflating asset prices by encouraging investors and speculators to shift out of low-yield assets like Treasury securities into higher-yielding assets like commodity contracts or other tangible financial assets.

But we thought the Fed's monetary policy has no impact on asset price bubbles. Didn't the Chairman himself say so a few days go. The St. Louis Fed squarely disagrees with this assesment:

Fed Chairman Ben Bernanke and other senior Fed officials are quite confident that they have the tools and the determination necessary to prevent an unwelcome acceleration in inflation or inflation expectations. Unlike previous episodes, though, the magnitude of the policy responses to the financial crisis and the Great Recession suggests that the FOMC’s margin of error seems much smaller than at any time in the Fed’s history.

And if history is any indication, it is a virtual certainty that Bernanke will commit an error once again in his monetary policy calculations. The only question is what the magnitude of the error will be, and how dire the bubble-popping implications become once the asset-price inflation episode comes to an abrupt end.

Full St. Louis Fed paper: