« Policies for Increasing Economic Growth and Employment | Main | Consumption Prospects and Rebalancing »
Is it reasonable to worry about inflation in the current environment?
With unemployment likely to stay near 10% for the next year, it is hard to imagine wage inflation returning any time soon. In October I illustrated a simple Phillips curve relation that could be used to forecast the inflation rate over the next two years as a function of the realized inflation rate over the previous five years along with the current unemployment rate. The figure below updates that forecast using the December unemployment numbers. The relation is still calling for deflation, not inflation, over the next two years.
Downward pressure on rents is another factor that makes a surge in the large owner-equivalent-rent component of the CPI unlikely. Why then would anybody expect an immediate resurgence of inflation?
Greg Mankiw offers this analysis:
One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods. A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall....
The federal government's budget deficit was $390 billion in the first quarter of fiscal 2010, or about 11 percent of gross domestic product. Such a large deficit was unimaginable just a few years ago. The Federal Reserve has also been rapidly creating money. The monetary base-- meaning currency plus bank reserves-- is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years. Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases....What gives?
Part of the answer is that while we have large budget deficits and rapid money growth, one isn't causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama's spending but to rescue the financial system and prop up a weak economy.
I see this last issue a little differently from Greg. I would emphasize that there are a number of components that could contribute to future fiscal deficits. These include not just the standard concerns about whether taxes will be raised sufficiently to cover growing entitlements-- and that by itself is of course a huge issue-- but also prospective expenditures needed to make good on the government's guarantees of the obligations of institutions such as Fannie, Freddie, and the FDIC, whose notional commitments exceed the entire federal debt held by the public. The business of making such loan guarantees is by its nature a decision of fiscal as opposed to monetary policy. But having the Fed absorb credit risks that private actors will not is the essence of the new monetary policy adopted by the Federal Reserve over the last year and a half. I furthermore am persuaded that the Fed assumed these obligations precisely because the U.S. Congress was unwilling to authorize such actions as an explicit fiscal act. As I wrote in my contribution to the recent book, The Road Ahead for the Fed:
If I were the chair of the Federal Reserve, I would want to be asking, "why was I invited to this party?" The answer unfortunately appears to be, "because you're the one with the deep pockets." That the Fed should find itself in a position where Congress and the White House are viewing its ability to print money as an asset to fund initiatives they otherwise couldn't afford is something that should give pause to any self-respecting central banker.
Greg Mankiw's source of reassurance is thus the cause of my personal anxiety. I think the separation between monetary and fiscal policy has become increasingly blurred. I maintain that the keys to preventing a resurgence of inflation in the U.S. are (1) credible and responsible commitment from Congress that it is not going to allow the debt-to-GDP ratio to continue to balloon over the next decade, and (2) a return of the Federal Reserve to a primary focus on controlling the money supply rather than trying to target particular yield spreads.
And what about the monetary expansion we've seen already? Here is Greg's analysis:
As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.
For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.
And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well.
Here again I differ from Greg. I see no conceptual distinction between short-term T-bills issued by the Treasury and interest-bearing reserves created by the Fed. Both represent liabilities from the government that must be repaid with interest. The Treasury should not assume it can always roll over an increasing volume of debt simply by issuing more debt, nor should the Fed assume that it can always persuade banks to continue to hold a trillion dollars in excess reserves simply by exercising its one true power-- the ability to print more money. The value of the new Federal Reserve liabilities ultimately will be determined by the long-term fiscal soundness of the U.S. government.
Let me nevertheless again emphasize that I don't see these dynamics playing out in the form of a near-term surge in inflation, for the reasons I spelled out in the beginning. Inflation is not something you should be afraid of for 2010. But what we need is a convincing commitment from the government to both near-term stimulus and longer-term fiscal responsibility in order to be assured that it's not a concern over the next decade.
And that's not what I'm seeing from the U.S. Congress.
Posted by James Hamilton at January 19, 2010 08:15 PM
"As the economy recovers, banks may start lending out some of their hoards of reserves."
I think that is just plain wrong. Banks don't lend out reserves.
See this link:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/money-banks-loans-reserves-capital-and-loan-officers.html
and comment by JKH at November 29, 2009 at 05:32 PM (WARNING: long comment)
The argument is banks are CAPTIAL constrained NOT reserve constrained.
Posted by: Get Rid of the Fed at January 19, 2010 09:41 PM
"The Federal Reserve has also been rapidly creating money. The monetary base-- meaning currency plus bank reserves-- is the money-supply measure that the Fed controls most directly."
I hope you can explain to everyone why they chose bank reserves and not currency. I want to see that.
Posted by: Get Rid of the Fed at January 19, 2010 09:47 PM
"Here again I differ from Greg. I see no conceptual distinction between short-term T-bills issued by the Treasury and interest-bearing reserves created by the Fed. Both represent liabilities from the government that must be repaid with interest."
Some people can claim that interest-bearing reserves created by the Fed are actually gov't debt in disguise (since the gov't as it is now won't let the fed fail) with a term of overnight. Plus, why should the gov't (taxpayers) back up liabilities from the fed that help their banking buddies?
Posted by: Get Rid of the Fed at January 19, 2010 09:53 PM
"The Treasury should not assume it can always roll over an increasing volume of debt simply by issuing more debt, nor should the Fed assume that it can always persuade banks to continue to hold a trillion dollars in excess reserves simply by exercising its one true power-- the ability to print more money."
IMO, you should NOT use the phrase "print more money". IMO, the fed can print currency or can "print" bank reserves. Using "print more money" can confuse people.
Posted by: Get Rid of the Fed at January 19, 2010 09:58 PM
"I maintain that the keys to preventing a resurgence of inflation in the U.S. are (1) credible and responsible commitment from Congress that it is not going to allow the debt-to-GDP ratio to continue to balloon over the next decade, and (2) a return of the Federal Reserve to a primary focus on controlling the money supply rather than trying to target particular yield spreads."
I keep recommending this essay, because the point of it is to do just that with a series of constraining and reinforcing policies:
Milton Friedman "A monetary and fiscal framework for economic stability"
I'm not arguing that we need to follow his plan exactly, but it does provide a basis for resolving these issues.
Posted by: Don the libertarian Democrat at January 19, 2010 10:00 PM
Have you heard of "long and variable lags" in monetary policy effects? It takes about a year or more to see a peak effect on real GDP growth and about two years or more to see a peak effect on inflation. So yes, there will be no high (core)inflation in 2010, but high inflation later on is inevitable. Any monetary tightening to prevent that will be too late.
Posted by: Darko Oracic at January 19, 2010 11:56 PM
In theory I agree with Greg's article. However, reality might be a bit different.
The Fed CAN sell MBS's and raise rates on bank reserves, for example, if inflation starts heating up. But will it do so if unemployment is near 10%?
The inflation story is not about the Fed's ability to control inflation, but its willingness to control inflation.
Posted by: Plan B Economics at January 20, 2010 03:04 AM
Freedom is not about having a good master, but to have none. Cicero
One may have to read the depraved translation of the above statement as follows;
Central banks are independent (ECB) or deemed to be(Fed) and yet they rescued the recurrent fiscal government spendings. The states bonds auction regulations are stating that liquidity and primary dealers dis-hoarding are the cornerstones of these markets and yet primary dealers have been and are encouraged to do otherwise. Basle 1, B2, B+n prudential ratios dissuade risk concentration,excess leverage on capital funds and yet no or only few banks are and were in compliance. When derivatives have proved to be an instrument of leverages and prices distortion, many public voices were broadcasting the outrage.They may have found that compliances with prudential ratios including derivatives, may drive public bonds prices down and their interest up. Banks liquidity ratios have been thought for the purpose of alleviating systemic financial risks (merely dissuading banks to borrow short term money as a mean to finance long term assets) Should one be willing to dig further.please read the ECB monthly bulletin where M1,M2,M3 are available)
This is an economy of distorted capital allocation that was states controlled, leaving the most genuine thoughts of money supply,interest rates as an oddity.
Posted by: ppcm at January 20, 2010 05:12 AM
Read Full Article »