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The Fed and Inflation, Late Again?

Posted By J.D. Foster, Ph.D. On February 24, 2010 @ 1:25 pm In Economics | Comments Disabled

The Federal Reserve Building [1]

Inflation is ultimately and always a monetary phenomenon.  The Federal Reserve’s extraordinary actions during the recent crisis now require executing a difficult exit strategy without short-circuiting the recovery and most especially without letting inflation get out of control.  Comments by Fed officials beginning with Chairman Ben Bernanke suggest they are committed to containing inflation and the Fed appears to have the tools to do so.  But will they use those tools wisely?  A specific, consistent thread in Bernanke’s comments suggest the Fed will yet let inflation get out of the bag despite the best intentions and tools.

The substance of the inflation threat is in two parts. The first is the trillion dollar mountain of bank excess reserves the Fed has created and that are now idling on the Fed’s balance sheet.  If banks choose to begin tapping these reserves in large quantities, drawing them into the credit creation process, then the economy may get a welcome initial pop, soon to be followed by rapid resurgent inflation.  The Fed has new tools, especially its ability to pay interest on excess reserves that should allow it to modulate the outflow of excess reserves [2].

Central to the Fed’s response in the recent crisis was the reduction of the Federal funds rate essentially to zero.  At some point, the Fed must begin raising the funds rate toward a more normal, more neutral level.  If the Fed is late in raising the funds rate, as it was late coming out of the last recession and as it was late in cutting the funds rate at the onset of the crisis, then even if it controls the outflow of excess reserves another spate of asset price bubbles is possible and unacceptably high inflation becomes likely.

The Fed has substantial credibility when it signals its intent to fight inflation.   However, danger lurks in the Chairman’s words.  The root of the danger is the pervasive belief that economic weakness in the form of substantial excess capacity and high unemployment will persistently dampen inflationary pressures.   Whatever effects excess capacity has on inflation pressures in the short run, those pressures disappear before long [3] (PDF is in draft form)

This recalls an earlier episode in the late 1960s and 1970s when economists believed they could buy a reduction in the unemployment rate at the cost of a modest increase in inflation.  It turned out this fleeting bargain quickly produced stagflation – high unemployment and high inflation.  The current thinking is just the converse – the belief that high unemployment buys low inflation.  It does not work this way, either.

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URL to article: http://blog.heritage.org/2010/02/24/the-fed-and-inflation-late-again/

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[1] Image: http://www.foundry.org/wp-content/uploads/the-fed100224.jpg

[2] pay interest on excess reserves that should allow it to modulate the outflow of excess reserves: http://www.heritage.org/Research/Economy/bg2371.cfm

[3] those pressures disappear before long: http://thf_media.s3.amazonaws.com/2010/pdf/bg2380-draft.pdf

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