Have we gotten to the point where the Federal Reserve ought to start targeting a higher rate of inflation?
As someone who came of age during the Great Inflation of the 1970s and was looking for my first job just as Paul Volcker was trying to exorcise the demons, I never thought I’d ever say anything like that.
But I’m not so sure anymore. The idea is getting more attention, and it may pick up even more if the United States slips closer to actual deflation.
Paul Krugman has been making that argument, noting today that the real interest rate on 5-year inflation-protected Treasuries is actually -.2 percent. He also pointed out on Monday that Ben Bernanke made a similar case back in the 1990s, arguing that Japan’s central bank should target a rate of 3 or 4 percent in order to pull the country out of its deflationary slump.
Bernanke doesn’t say anything of that sort about the United States today. And when the idea surfaced briefly at the Fed’s Jackson Hole retreat in 2009, it got firmly slapped down by then vice-chairman Donald Kohn. Just as the Great Depression imprinted a generation of Americans to avoid risk, the Great Inflation imprinted at least a generation of economists to focus on price stability. And who could argue? The 80s and 90s showed that low inflation could go hand-in-hand with high employment and rising wealth. In fact, they seemed to reinforce each other: stable prices provide more certainty about the future, which is good for investment.
Then again, the United States never had a Fed funds rate of basically zero. And for all the Fed’s cheap money, long-term Treasury rates are hovering around 2.7 or 2.8 percent. How much lower can rates go?
We don’t have deflation, at least not yet. But inflation is down to about 1 percent a year, which is lower that Fed officials want, and it’s falling. Meanwhile, unemployment is nearly 10 percent and economic growth is stalling. In fact, the new trade deficit jump for June and recent changes to inventory estimates mean that GDP growth in the 2nd quarter will be revised down a lot from than the government flash estimate last week of 2.4 percent. And that was bad enough.
Yesterday’s Fed announcement suggests that Bernanke and his colleagues think things may get worse. I admit that I initially yawned at the FOMC statement. The Fed admitted that the economic growth had “slowed” and that the recovery would be “more modest” than it had expected. Didn’t everybody already know that? It also announced that it would reinvest proceeds from its massive bond portfolio rather than let it shrink. In itself, it’s nothing more than a symbolic gesture that “we care.”
But Larry Meyer of Macroeconomic Advisers, arguably the most plugged-in Fed analyst in the country, admits he was genuinely surprised by the Fed’s pessimism. Though the Fed statement didn’t offer any new numbers, Meyer now believes that the Fed’s forecasts are substantially more pessimistic those of his own firm.
We took two important messages from the statement: First, the staff and the Committee’s forecasts have now diverged significantly from MA’s, with weaker growth than MA in both 2010 and 2011. Second, the question now is not how late they will tighten, but whether, when, and how they will ease.
A lot of wags are saying that Bernanke has already set sail on the QE 2 — not the ship, just Round Two of a “quantitative easing” program to buy up a trillion or so worth of Treasuries and drive down long-term rates.
I hope it isn’t necessary. As Stuart Hoffman of PNC Financial remarked yesterday, “it’s not necessarily good news if the Fed decides the economy is so bad that it’s time to start asset purchases again.”
But what if the U.S. really does slip into deflation and recession? Should the Fed publicly push for higher inflation?
There are all kinds of reasons to say no. For one thing, it may not work. Cheap money hasn’t led to a flood of new lending or investment – banks have simply parked about $1 trillion in excess reserves at the Fed. Beyond that, it’s an extremely baffling message to send the public. The political storm would be huge – just recall Ron Paul’s “End the Fed’’ movement, and multiply that a hundred times. More importantly, the Fed could unleash escalating inflation expectations that would be a nightmare to get them back down (ask Volcker). The Fed would risk losing the credibility it spent decades amassing. Finally, there’s the nightmarish possibility that we’d simply create another wave of speculative bubbles.
But here are the possible reasons for saying yes. 1) If we do slip into deflation, a public target to higher inflation might be the only way to communicate the Fed’s commitment. 2) Interests can’t sink much lower than they are already; 3) The long-run target doesn’t necessarily have to change at all. The Fed could simply say it is targeting faster inflation until prices get back up to the level the would be at if inflation had been normal at 1-2 percent.
To be honest, I’m not at all sure I believe any of this myself. I’m not Paul Krugman. I’m just a layman. But we are already through the looking-glass, and we have been ever since Lehman weekend.