Members of the Federal Reserve Board of Governors don’t usually share their differences in public. On Oct. 11 the board’s vice chairman, Stanley Fischer, said in Lima that he expects a hike in the Fed’s main rate “later this year,” confirming what Chair Janet Yellen had said in September. Within two days, Lael Brainard and Daniel Tarullo, both on the board, said the Fed should wait because there wasn’t yet any sign of inflation. That disagreement shows the dilemma Yellen faces: Raise rates soon and risk smothering a tepid recovery, or wait until next year and risk igniting inflation.

Congress gave the Fed two jobs: Keep inflation predictable and unemployment low. In the past, as unemployment went down, inflation went up. Fed hawks argue that, with unemployment at 5.2 percent, inflation is on its way. Doves say that relationship isn’t what it used to be. There’s a third argument: We don’t really know how well the last seven years of Fed policy have worked. And if the central bank can’t be sure of what happened in the past, it will find it hard to decide on the future.

The Fed can’t tell banks how to lend. Instead, it relies on something measurable that it can control: the rate of interest. Since 2008, the Fed has kept short-term rates near zero and brought long-term rates down through “quantitative easing.” That required the central bank to buy a lot of long-term U.S. government debt. By lowering long-term rates, QE would encourage people to buy houses, and businesses to borrow for expansion.

While QE succeeded in bringing down long-term rates, lending didn’t increase as much as anticipated. The Fed hit its interest rate target square on. It’s hard to measure how much easing has benefited Main Street. Some economists are skeptical. “We no longer believe that QE can fix everything,” says Michala Marcussen, global head of economics at Société Générale.

David Fuller's view

Commodity prices will be the best indicator for inflation.  Keep a close eye on the Continuous Commodity Index (Old CRB).  Short selling, lower demand from China and overproduction drove it lower prior to the latest mean reversion rally towards the declining 200-day MA. 

The latest rally has been helped by supply cutbacks from Glencore, which led to some short covering.  Of the three factors mentioned above, commodity production is the key variable.  Every bearish commodity cycle that I have witnessed over the last 50 years, including the 2008 low, has ended because of supply cutbacks.  That process has now begun.  The speed with which it spreads will determine how quickly commodity prices rise.  This factor will be more important than GDP growth in reviving inflation over the next year or two.