Martin Feldstein on Inflation

In a piece written on Monday for the Financial Times, professor Martin Feldstein discusses the rise in Treasury yields and how he sees that rise as an indication of inflationary pressures building across the economy. The interest rate on T-10 bonds nearly doub­led in the last 2q’s, rising from 2.26% last December to 3.98% in mid-June, before de­creasing last week. In further noting inflationary factors facing the economy, prof. Feldstein also notes in his piece, that the sharp rise on 10-year T bond occurred despite the Fed’s QE policy aimed at lowering long-term rates by buying $300 billion of Treasuries and promising to buy more than $1 trillion of mortgage securities.

From the FT:  The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. Although economic weakness and excess capacity are keeping current inflation low, the explosive rise of bank reserves created by Fed policy provides fuel for future inflation.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. These long-term concerns can have adverse effects on the prospects for recovery during the coming year. The immediate challenge to the US government is to reassure investors about both the risks of inflation and the projected growth of fiscal deficits.

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

The Fed continues to be confronted with a number of mix signals from the markets. While Treasury yields and mortgage rates are off of their peak levels, a weak greenback and rising commodity prices appear to be triggering some inflation concerns. Also to keep in mind here is the fact the markets have started pricing in a significant amount of Fed tightening by early 2010. We think that’s not an objective perspective, in terms of what the economic conditions and market dynamics dictate. Our own view is that a hike in the fed funds rate target will occur only after mid-2010, not prior.

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