If inflation is now above Bernanke’s comfort zone, as per Yellen who has been more dovish than Bermanke, and above their long-term target of maybe 2%, it can only be brought down by maintaining an output gap greater than zero under the mainstream theory they all subscribe to.

Particularly with the negative supply shocks of food, crude, and import/export prices persisting. And with energy prices (headline CPI) now showing up in core prices, also as per Yellen, inflation expectations are showing signs of coming unglued.

And the fiscal package has likely increased the Fed’s growth forecasts (smaller output gap) for Q2, Q3, and Q4.

The Fed believes a zero output gap means about a 4.75% unemployment rate.

That means the Fed wants to keep the economy from deteriorating and unemployment from rising, but it also doesn’t want unemployment falling to 4.75% which would mean it would have to act (rate hikes) to get it back up to something over 5% to meet long-term inflation targets.

So while Bernanke can say he stands by to do everything necessary to avoid a financial collapse, he also can’t allow the output gap to go to zero.


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