Where is the Inflation Monster Hiding?

For the past several years, there has been concern that higher inflation is just around the corner. It is a valid concern, given the damage that high inflation can wreak on an economy and the Fed’s expansion of the money supply. But caution should be exercised in attempting to preempt rising inflation since the facts on the ground do not support these fears and deflation can be equally if not more damaging.

The high inflation worries stem from the fact that the central banks, especially the Federal Reserve through Quantitative Easing, have pumped so much money into the economy for the last six years that some believe it is just a question of time before the double digit inflation of the 1970s return. Given the sums involved, this is not an unreasonable fear, but so far the central banks of these countries have failed to reach their inflation target of 2%.  In the Eurozone the current inflation rate is about 0.50%, barely one fourth of its target. In Japan, the target was increased from 1% to 2% in order to try raising inflationary expectations to prevent further deflation, as the monetary expansion that was supposed to produce inflation has failed.

What is going on?  It looks like some economists – those who predict higher inflation – are using the wrong model to support their specious views.  Normally, an increase in money supply coupled with a tight labor market would indicate current or imminent inflation. A labor market is tight when employers have difficulty filling jobs. The inflation hawks argue that jobs are going unfilled because workers do not have the skills demanded by employers.

However, the facts do not support this supply side interpretation.  The unemployment rate is higher today for all levels of education and all types of jobs than it was in 2007; thus it cannot be explained by a lack of skills.  Moreover, if companies were desperate to attract scarce skilled workers, we would expect to see them raising wages. But the wages of the workers who are supposedly in short supply have remained stagnant. The truth of the matter is that workers are unemployed primarily because firms are not hiring as they face a lack of demand for the goods and services that they produce.

This is not a supply side problem, but a demand side problem. The lack of demand is explained by what economist Richard Koo calls a “balance sheet recession”. Following the subprime crisis, people have been reducing their debt and rebuilding their balance sheets. The higher private savings rate means weak consumption, i.e. demand. Thus firms have not found it necessary to expand production.

As the gridlock in congress has resulted in a lack of fiscal stimulus, the central bank was forced to act with the only lever it has: monetary policy. The Fed has used two tools to expand the monetary supply in order to boost growth. First, it has reduced short-term (nominal) interest rates to almost zero. Second, it lowered long-term interest rates by buying longer-term bonds such as mortgage backed securities and “operation twist[1]”.

Thanks to those policies, the U.S. economy has been recovering faster than all European countries that implemented austerity measures.  As the U.S. economy slowly recovers, the Fed has started to taper its quantitative easing and has signaled that once tapering is complete toward the end of 2014, its next move will be to return short term interest rates slowly and eventually to a more normal level.  Indeed, the effects of the Fed’s plans have already influenced current long-term interest rates.  Because long-term interest rates are influenced by the expectations of futures short term interest rates controlled by the Fed, the yield curve has become somewhat steeper as long-term rates have started to rise slowly.  It is important to realize that it is not the expectations of higher expected inflation that has caused long term interest rates to rise somewhat, but instead the expectations of higher expected short-term interest rates that are controlled by the Fed at the same time that the Fed is purchasing fewer long-term bonds (tapering).  Through its unconventional monetary policy, including forward guidance and the purchase of long-term bonds, the Fed can influence long-term interest rates, as seen in their current behavior.

Despite the Fed’s moves, some, myself included, worry that the Fed may have started tightening monetary policy too early. The inflation rate remains below its target and the economy is still not fully recovered.  The cost of a little higher inflation, conceivably a bit above two percent, is probably worth the benefit of reducing unemployment faster (ask an unemployed worker!).  Higher inflation would reduce the burden on debtors, who have a higher marginal propensity to consume than creditors, who are not budget-constrained, and would lower real interest rates since nominal interest rates are near the zero-lower-bound and thus are unable to fall further.  Thus higher inflation would likely boost economic expansion.

Those worried about the return of high inflation question the capacity of the Fed to engineer an eventual return to full employment while maintaining an inflation rate close to 2% (the Fed dual mandate).  They do not believe that the Fed will be able to manage the withdrawal of liquidity from the economy as soon as it becomes desirable to do so.  As mentioned above, the Fed has already started along that route, by tapering and signaling that short term interest rates will rise in the not-too-distant future.  At the current pace, tapering should be complete by the end of this year; the Fed will then start reducing the size of its balance sheet, by letting some assets expire and by selling others.  Moreover the central bank has other tools at its disposal; it can increase the interest rates on Reserves (currently 0.25%) that it pays on the deposits of commercial banks.

No, we are not experiencing a return to the 1970s; instead, the parallel is more like 1937, when the Fed was fearful of rising inflation and reversed the tepid economic expansion underway by raising interest rates.  Hopefully, the policy makers of the Fed are more enlightened today and will not repeat history. Prematurely raising interest rates could exacerbate our low demand problem, and unnecessarily lengthen our economic malaise.  As Japan’s decades long example has shown, increasing inflation can be extremely difficult.

Merely increasing the money supply will not cause inflation.  As long as the money that is created is held by banks as reserves and not lent to firms to engage in the investment spending we would like to see, inflation (and the economic recovery) will remain subdued.  The demand for goods and services must increase before prices start rising.  This will require a more expansionary fiscal policy to complement monetary policy (for example, some kind of tax incentives to boost investment and consumption or increased infrastructure spending).  As demonstrated by an IMF paper published during the crisis, government spending has a higher multiplier effect during periods of economic slowdown.  Let’s not allow history to repeat itself causing unnecessary harm to the millions of involuntarily unemployed and underemployed people.  The risk of a “deflationary spiral” whereby consumers delay their purchases believing that prices will stay low or fall further, thereby slowing overall economic growth and causing businesses to respond by reducing their activities, should  not be dismissed.

So let’s put aside the inflation worries for now and focus on our primary economic problem today: unemployment!

Pierre Canac, Ph.D.
Associate Professor of Economics

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