Why Inflation Is Not a Risk

"The best guarantee for maintaining low inflation after the current recession is for the Obama administration to protect the independence of the Federal Reserve."

The US financial markets are haunted by ghosts. Many are alarmed at the prospect that the Federal Reserve’s highly accommodative monetary policies could revive inflation. Prominent economists, including Alan Greenspan, Martin Feldstein, and Arthur Laffer, have penned articles warning that higher inflation lies ahead. As the economy has recently experienced a modest touch of deflation, there is little doubt that prices will increase, but it is difficult to imagine a serious resurgence of inflation for many years.

There are several potential constraints on inflation. First, the economy currently has an unprecedented output gap. The current level of real GDP is about 7% below its long-term trend, so the economy has a large supply of underutilized resources. As final demand in the coming economic recovery will be constrained by deleveraging and wealth losses, it is quite possible that this output gap could expand further during 2010. In fact, unemployment could easily approach 11% by early next year.

The economy generates inflation either through demand pull or cost push factors. If final demand is weak, it will be difficult for firms to raise prices. It is possible that a recovery of the Chinese economy could boost commodity prices, but raw materials account for only a small share of output costs. The most important factor is labor costs. If unemployment is at 10% or higher, there will be little upward pressure on wages. On the contrary, many firms are now obtaining wage cuts.

It is true that there has been a significant expansion of the Federal Reserve balance sheet which could open the door to faster money growth and higher inflation at some point in the future. Excess reserves in the banking system have grown to nearly $900 billion from only $10 billion one year ago. But the mechanism by which excess reserves evolve into higher inflation is a significant expansion of credit growth. During the past six months, US banks have been shrinking their loans and leases at an annual rate of 14%. The government has been able to run massive fiscal deficits without pushing bond yields significantly higher because of declining private credit demand.

As Fed Chairman Ben Bernanke has explained in recent congressional testimony, there are ways the Fed can attempt to neutralize the huge growth of bank reserves if the economy recovers and credit growth begins to revive. The Fed can pay higher interest on the excess reserves or engage in repo operations to reduce the market’s excess liquidity.

Japan experienced a massive expansion of its central bank balance sheet during the early years of this decade. It grew from 5% of GDP to nearly 30%. The increase in liquidity helped to depress government bond yields, but it did not trigger resurgence of lending or inflation because banks were still adjusting to the huge loan losses on their balance sheets. It is likely that US banks will experience another $600 billion of loan losses by the end of 2010, so the US is also likely to experience a balance sheet recession. In a balance sheet recession, banks are capital constrained and borrowers are reducing their leverage. After the collapse of the bubble economy during the early 1990’s, Japanese firms spent an entire decade reducing their debt. The US corporate sector is not as highly leveraged as Japan’s was in 1990, but the recession has made the US corporate sector highly risk adverse. It is unlikely to resume borrowing and investing until there is a sustained upturn in the capacity utilization rate. The household sector is now reducing its leverage for the first time in decades.

The best guarantee for maintaining low inflation after the current recession is for the Obama administration to protect the independence of the Federal Reserve. The administration should move quickly to fill the two vacancies on the FOMC by appointing highly competent economists. It should resist congressional pressures to impose new audits on the Fed which might open the door to more political interference in the bank’s operations. It should reappoint Ben Bernanke as Fed chairman for another term so that he can unwind the highly stimulative policies he pursued in order to combat the financial crisis. It is true that Mr. Bernanke was appointed by a Republican president, but he spent most of his career as an academic and is not highly partisan. If the administration were to appoint a Fed Chairman with a more partisan history, the risk is high that bond yields would rise because of market fears about the central bank monetizing the Obama fiscal deficits.

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