by Alan S. Blinder
SOME people with hypersensitive sniffers say the whiff of future inflation is in the air. What’s that, you say? Aren’t we experiencing deflation right now? The answer is yes. But, apparently, for those who are sufficiently hawkish, the recent activities of the Federal Reserve conjure up visions of inflation.
The central bank is holding the Fed funds rate at nearly zero and has created a mountain of bank reserves to fight the financial crisis. Yes, these moves are unusual, but these are unusual times. Concluding that the Fed is leading us into inflation assumes a degree of incompetence that I simply don’t buy. Let me explain.
First, the clear and present danger, both now and for the next year or two, is not inflation but deflation. Using the 12-month change in the Consumer Price Index as the measure, inflation has now been negative for three consecutive months.
It’s true that falling oil prices, now behind us, were the main reason for the deflation. Core C.P.I. inflation, which excludes food and energy prices, has been solidly in the range of 1.7 percent to 1.9 percent for six consecutive months. But history teaches us that weak economies drag down inflation — and ours will be weak for some time. Core inflation near zero, or even negative, is a live possibility for 2010 or 2011.
Ben S. Bernanke, the Fed chairman, is a keen student of the 1930s, and he and his colleagues have been working overtime to dodge the deflation bullet. To this end, they cut the Fed funds rate to virtually zero last December and have since relied on a variety of extraordinary policies known as quantitative easing to restore the flow of credit.
These policies basically amount to creating new bank reserves by either buying or lending against a variety of assets. But quantitative easing is universally agreed to be weak medicine compared with cutting interest rates. So the Fed is administering a large dose — which is where all those reserves come from.
The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. But their concerns are misplaced. To understand why, start with the basic economics of banking, money and inflation.
In normal times, banks don’t want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation.
In abnormal times like these, however, providing frightened banks with the reserves they demand will fuel neither money nor credit growth — and is therefore not inflationary.
Rather, it’s more like a grand version of what the Fed does every Christmas season. The Fed always puts more currency into circulation during this prime shopping period because people demand it, and then withdraws the “excess” currency in January.
True inflation hawks worry about that last step. (Did someone say, “Bah, humbug”?) Will the Fed really withdraw all those reserves fast enough as the financial storm abates? If not, we could indeed experience inflation. Although the Fed is not infallible, I’d make three important points:
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The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.
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The Fed is well aware of the exit problem. It is planning for it, is competent enough to carry out its responsibilities and has committed itself to an inflation target of just under 2 percent. Of course, none of that assures us that the Fed will hit the bull’s-eye. It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.
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The Fed will start the exit process when the economy is still below full employment and inflation is below target. So some modest rise in inflation will be welcome. The Fed won’t have to clamp down hard.
SKEPTICAL? Then let’s see what the bond market vigilantes really think.
The market’s implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rates on Treasury Inflation Protected Securities, or TIPS. These estimates change daily. But on Friday, the five-year expected inflation rate was about 1.6 percent and the 10-year expected rate was about 1.9 percent. Notice that the latter matches the Fed’s inflation target. I don’t think that’s a coincidence.
But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.
In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.
My conclusion? The markets’ extraordinarily low expected inflation in January was both aberrant and worrisome — not today’s. As long as expected inflation doesn’t rise much further, you should find something else to worry about. Unfortunately, choices abound.
Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians.
