In his latest Fed Watch post, Tim Duy prepares us for what he expects is the next debate.  With agreement among Fed officials that we are in for roughly 3.7% growth this year, one question is whether and when the Fed needs to adjust policies to moderate inflation.  And decision, it seems will come down to how the Fed reads job figures.  Duy writes:

Whatever you think of the nature of the recovery, there appears to be general agreement that some recovery is in place, what the Fed describes as “firmer footing.” The pace of job creation in the last six months appears consistent growth a little above trend. I think we can consider this improvement as a general increase in aggregate demand.

Note what occurs once demand rises sufficiently to pull output past the “kink” in the short run aggregate supply curve – there is suddenly room for upward pressure on prices. This appears consistnet with the general shift in risk away from deflation toward inflation. The situation could be somewhat more complicated if supply issues, particularly for oil, are putting upward pressure on the long run aggregate supply curve at the same time, but for the reasons given below this also does not need to impact our long run inflation story.

Importantly, we need to expect such pressure to continue as the price level rises until output reaches its potential. In short, the rising prices can coexist with large output gaps. How does this translate into likely the likely path of inflation? The way I think about it is that prices return to their prerecession trend:

This implies that reestablishing long-run equilibrium entails a period of relatively higher inflation. And that inflation will create significant unease among a certain group of policymakers (and investors, for that matter).

Read Fed Watch:Back to Basics here.