When the economic crisis first hit in 2008, the Federal Reserve was very quick to sharply expand the money supply to keep the financial system from imploding the way it collapsed in the early 1930s, which brought on the Great Depression. When the Fed expanded the money supply, there were many economists who immediately warned that the Fed’s action would shortly bring on massive inflation.
In the two years since, however, deflation has continued to be the economy’s fundamental problem. This has led some economists to suggest that in fact a bit of inflation would be the best possible thing for the economy today.
One aspect of this argument involves differentiating between two similar-sounding concepts of the Fed’s basic objective. On the one hand, you have those that believe the Fed should be targeting inflation. In essence that is what it already does. For some time it has said publicly that it aims to have an inflation rate of about two percent. But lately, the particular measure of inflation that the Fed follows has been running less than half that rate.
that are worth more than those they borrowed initially.
The second idea is that the Fed should target the price level. The difference is that this would permit a period of catch-up inflation after a period of deflation (falling prices). In other words, if the price level has fallen, the Fed needs to get it back up to where it started even if it means temporarily raising its inflation target.
A key reason why this is important is that deflation magnifies the burden of debt. In effect, people are forced to repay debts in dollars that are worth more than those they borrowed initially. The weight of debt therefore rises, imposing a crushing burden on the economy that inhibits spending, investment and growth. The great economist Irving Fisher thought this debt-deflation mechanism was at the core of the Great Depression. It may be the case now as well.
Some will respond that there is no deflation; the Consumer Price Index continues to rise. In August, it increased 0.3 percent — 3.6 percent on an annual basis, compared to an increase of 1.1 percent over the past year. However, there are very serious problems with using the CPI as the basic measure of inflation. First, it measures only a basket of goods and services regularly purchased by consumers. Perhaps the most important exclusion is prices for capital assets such as common stocks and housing, both of which have fallen far below their peaks.
The Bureau of Labor Statistics uses a rental-equivalent measure for the price of housing in the CPI. It adopted this procedure after the huge run-up of housing prices in the 1970s because the method it was using biased the CPI upwards — in effect, it assumed that people bought a new house every month. But the rental-equivalency measure has the same problem under deflationary conditions because the fall in housing prices is effectively excluded from the CPI.
Another problem is that consumer prices are “sticky.” Many studies have shown that producers and retailers change prices only very slowly in response to changing economic conditions. It may take months or even years before the CPI picks up all the underlying inflationary or deflationary forces.
Also, a number of important prices in the CPI are strongly resistant to market forces, the most important being health care. As everyone knows, prices for health insurance, drugs, hospitalization and so on rise relentlessly. Eventually, this will force down prices of other goods and services, but that only happens with a long lag. In the meantime, rising health care costs give the CPI an upward bias.
Finally, there are a number of technical problems that economists have identified with the CPI that they believe cause it to overstate inflation by about one percent per year. One of these problems is how to account for improvements in quality. Another is incorporating new goods into the index. If these technical problems were fixed, the CPI would likely have shown zero inflation over the past year.
The continued modest rise in the CPI notwithstanding, there is nevertheless good reason to believe that the fundamental economic problem is deflation. It is the very rare business these days that is able to raise its prices. Those that have been able to prosper are those that have relentlessly cut costs and improved productivity. Of course, cost-cutting and rising productivity contribute to deflationary pressure.
Those that continue to see inflation right around the corner basically fall back on economist Milton Friedman’s dictum that inflation is always and everywhere a monetary problem. The rise in the money supply must eventually bid up prices, the inflation hawks believe. It may not have happened yet, but it’s right around that corner, they say on a daily basis. They believe that is what is fueling a rise in the price of gold, as people buy coins, bullion and gold stocks as an inflation hedge.
Some people believe absolutely that the price of gold is the best leading indicator of future price trends that there is. Of course, there have been many occasions in the past when gold signaled inflation that never emerged. One reason is that policies can change. The Fed can put its foot on the monetary brake at any time, raise interest rates and reduce the money supply. And in the past it has done exactly that when it feared that inflation was getting out of control.
But there is another problem as well, which is that the price of gold may simply be the latest case of a price bubble and is rising not because of fundamentals but because of psychology. The high price of gold today may tell us no more about future economic or price tends than the high price of housing did in 2007 or the high prices of technology stocks in 2000.
The basic reason why the Fed’s huge increase in the money supply is not stoking inflation is that it is not being spent. It is simply sitting in banks gathering dust, so to speak. Until the money gets out into the economy via consumer spending and business investment, it cannot bid up prices and cause inflation.
This has led some economists to suggest that if the Fed could make people expect inflation, it would get the money moving again and create self-sustaining growth. The theory is that if people expect lower prices for things like houses they will put off purchases until they are certain that they have bottomed and are on the rise again. Thus deflationary trends reinforce themselves.
But if people expect prices to be higher in the future, they will buy now to lock in a low price. Thus inflationary trends also reinforce themselves. Expectations of future inflation, therefore, would cause people to buy and businesses to invest and get the money now sitting idle in banks out into the economy.
Many economists think the Fed could bring about this positive trend simply by announcing that it has raised its inflation target from two percent to three or four percent. If people believe the Fed means it will take actions to bring it about, then it becomes a self-fulfilling prophecy.
It’s a neat theory and it might work, but it hinges critically on the Fed finding a way, institutionally, of raising its inflation target and having the credibility that people will believe it. I have serious doubts on both counts.
It’s important to remember that the key policymaking arm of the Fed is the Federal Open Market Committee, which consists of the seven members of the Federal Reserve Board, who are appointed by the president and confirmed by the Senate, and five presidents of the 12 regional Federal Reserve banks, who are appointed by local boards of directors. The president of the New York Fed is a permanent member and the other four slots rotate. But in practice this is meaningless because at FOMC meetings all regional bank presidents are permitted to present their views and the committee operates largely on a consensus basis.
For institutional reasons, the regional bank presidents tend to be more hawkish on inflation than board members; and many have been saying for some time that the Fed should be tightening monetary policy. To offset this bias, it’s important that the seven members of the board speak as one and impress upon the bank presidents that a more expansive monetary policy is needed. But, unfortunately, three board seats are vacant because the Senate can’t be bothered to confirm them.
On September 21, the FOMC met to discuss monetary policy. Although its statement acknowledged that inflation was running well below its target, it nevertheless refused to announce any new measures to stimulate growth. Indeed, one member, Thomas Hoenig of the Kansas City Fed, said that the Fed should already be tightening monetary policy because he thinks inflation is a bigger problem than stagnant growth.
Getting the Fed to adopt a more expansionary monetary policy is a theoretical, institutional and political problem. What it will take to force action at this point is anyone’s guess. The one thing that unambiguously would help is to get the board to full strength so that there will be more voices at the next FOMC meeting urging action to counter those that fear inflation like little children fear the boogeyman.