Eventual Inflation Still a Concern

Of late, there have been a lot of worries about the potential for inflation in the U.S. Marc Faber is the most noted pundit in this regard. Over-the-top comments he made back in May about hyperinflation in the U.S. may have been a catalyst for all of the inflation talk. See my post Marc Faber: “I am 100% sure that the U.S. will go into hyperinflation” for more on Faber’s comments.

But Janet Yellen, the Chairman of the San Francisco Fed and a potential successor to Ben Bernanke, is having none of this. She gave a speech yesterday at the Commonwealth Club, which was widely followed – in part due to talk about her succeeding Bernanke. There, she was very dovish on inflation, at least over the near term. In her view, the deflationary risks associated with this downturn will keep the Fed’s bias toward policy accommodation.

Here is the crucial passage in her speech (emphasis added):

Let me now turn to an issue that has lately garnered a great deal of attention—inflation. Just a short time ago, most economists were casting a wary eye on the risk of deflation—that is that prices might drop, perhaps falling into a downward spiral that would squeeze the life out of the economy. Now, though, all I hear about is the danger of an outbreak of high inflation.

I’ll put my cards on the table right away. I think the predominant risk is that inflation will be too low, not too high, over the next several years. I take 2 percent as a reasonable benchmark for the rate of inflation that is most compatible with the Fed’s dual mandate of price stability and maximum employment. This is also the figure that a majority of FOMC members cited as their long-run forecast for inflation, according to the minutes of the committee’s April meeting.
First of all, this very weak economy is, if anything, putting downward pressure on wages and prices. We have already seen a noticeable slowdown in wage growth and reports of wage cuts have become increasingly prevalent—a sign of the sacrifices that some workers are making to keep their employers afloat and preserve their jobs. Businesses are also cutting prices and profit margins to boost sales. Core inflation—a measure that excludes volatile food and energy prices—has drifted down below 2 percent. With unemployment already substantial and likely to rise further, the downward pressure on wages and prices should continue and could intensify. For these reasons, I expect core inflation will dip to about 1 percent over the next year and remain below 2 percent for several years.

If the economy fails to recover soon, it is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more. But I don’t view this as likely. The vigorous policy actions of the Fed and other central banks, combined with sizable fiscal stimulus here and abroad, have sent a clear message that deflation won’t be tolerated.

On the whole, I would agree with this point of view. And Reuters does a good job of summing up the main takeaways from her speech (article linked at the bottom). But, I would make a few caveats. First, just because deflation is the primary risk at present, does not mean that we shouldn’t be worried about eventual inflation. The Fed should be devising exit strategies away from policy accommodation because it is unclear that they have one. That said, the fact that the Fed can now pay interest on reserves is an often overlooked new tool in the Federal Reserve’s arsenal. I could see the Fed using this as a means to keep all of the excess reserves now in the system from being lent out as it sells off assets to soak up liquidity.

But it is clear that Yellen thinks the Fed should err on the side of accommodation. The mantra: ‘Don’t fire monetary policy bullets until you see the whites of inflation’s eyes.’ To me this means that eventual inflation risk is real despite Yellen’s present fears of deflation. In early June, I said in my post “Central banks will face a Scylla and Charybdis flation challenge for years”:

So, you have a huge amount of excess reserves, hard to sell assets on the Fed’s balance sheet. Add in the fact that the Federal Reserve is going to be loathe to choke off an incipient recovery and you have the makings of inflation when recovery takes hold.

Moreover, there is a rise in commodity prices which is adding inflation to the pipeline. Much of the recent decrease in headline inflation numbers is due to the collapse in commodity prices. But, Copper is near a seven-month high. Oil is near a seven-month high. And all of the agricultural and industrial commodities are taking off again. As China ramps up its economic stimulus, the recent increases in the ISM manufacturing data in the U.S. and elsewhere point to an increasing demand for industrial commodities, and this is inflationary.

In sum, any pickup in the economy is going to be met by a host of inflationary forces. This is one reason that bond yields have been increasing and the spread between the two-year and 10-year U.S. government bond is near a record.

While yields have eased of late, this dynamic is still at work. Yes, deflation should be the Fed’s primary concern right now because the economy is still very sick. However, when the economy does rebound, inflation is going to be a real challenge.

Sources
President’s Speech: Presentation to the Commonwealth Club of California, San Francisco, CA (pdf version here) – San Francisco Fed website
Yellen says Fed should not rush to reverse policy – Reuters

Comments

[Mad Hedge F...:]

Not according to Janet Yellen. I spent the evening with Dr. Janet Yellen, the president of the Federal Reserve Bank of San Francisco. She thinks that thanks to the government’s tax cuts and spending programs, we will be out of the recession by the end of this year. After massive inventory liquidation, the auto industry in particular is poised for a rebound. Financial markets are now in better condition than we imagined possible six months ago. However, the pace of the recovery will be frustratingly slow, and it could take several years to return to full employment. Since the majority of the Fed board members feel that inflation will be stuck at 2% for years to come, deflation presents a greater risk than inflation. We are not by any means out of the woods yet. Rising energy prices and interest rates are a potential drag on the economy. Commercial real estate is at the top of her worry list, as falling rents and capital values could create a downward spiral, further impairing the banks. China’s wishes for an alternate reserve currency are impractical. Answering questions as only a UC Berkeley professor can, she further confirmed my belief that we are looking at an “L” shaped recovery at best. However, she did pour some cold water on my idea that the TBT has further to run. “Inflation running up to untoward levels doesn’t make any sense,” she averred.

Jul 01 11:31 AM

[Dave Wrixon:]

I wouldn't concern yourself. Inflation is assured. You can rest easy. LOL

Jul 01 02:22 PM

[conceptwizard:]

Income paid to reduce debt is not available for spending on goods and services. It therefore shrinks the economy, aggravating the depression. So why is the jump in “saving” good news?

It certainly is a good idea for consumers to get out of debt. But the media are treating this diversion of income as if it were a sign of confidence that the recession may be ending and Mr. Obama’s “stimulus” plan working. The Wall Street Journal reported that Social Security recipients of one-time government payments “seem unwilling to spend right away," while The New York Times wrote that “many people were putting that money away instead of spending it.” It is as if people can afford to save more.

The reality is that most consumers have little real choice but to pay. Unable to borrow more as banks cut back credit lines, their “choice” is either to pay their mortgage and credit card bill each month, or lose their homes and see their credit ratings slashed, pushing up penalty interest rates near 20%! To avoid this fate, families are shifting to cheaper (and less nutritious) foods, eating out less (or at fast food restaurants), and cutting back vacation spending. It therefore seems contradictory to applaud these “saving” (that is, debt-repayment) statistics as an indication that the economy may emerge from depression in the next few months. While unemployment approaches the 10% rate and new layoffs are being announced every week, isn’t the Obama administration taking a big risk in telling voters that its stimulus plan is working? What will people think this winter when markets continue to shrink?

I think the Fed is on the money with deflation

Jul 01 02:33 PM

[Dave Wrixon:]

If the Fed is on the money with deflation, then its projections on recovery have certainly been a little too optimistic.


On Jul 01 02:33 PM conceptwizard wrote:

> Income paid to reduce debt is not available for spending on goods
> and services. It therefore shrinks the economy, aggravating the depression.
> So why is the jump in “saving” good news?
>
> It certainly is a good idea for consumers to get out of debt. But
> the media are treating this diversion of income as if it were a sign
> of confidence that the recession may be ending and Mr. Obama’s “stimulus”
> plan working. The Wall Street Journal reported that Social Security
> recipients of one-time government payments “seem unwilling to spend
> right away," while The New York Times wrote that “many people were
> putting that money away instead of spending it.” It is as if people
> can afford to save more.
>
> The reality is that most consumers have little real choice but to
> pay. Unable to borrow more as banks cut back credit lines, their
> “choice” is either to pay their mortgage and credit card bill each
> month, or lose their homes and see their credit ratings slashed,
> pushing up penalty interest rates near 20%! To avoid this fate, families
> are shifting to cheaper (and less nutritious) foods, eating out less
> (or at fast food restaurants), and cutting back vacation spending.
> It therefore seems contradictory to applaud these “saving” (that
> is, debt-repayment) statistics as an indication that the economy
> may emerge from depression in the next few months. While unemployment
> approaches the 10% rate and new layoffs are being announced every
> week, isn’t the Obama administration taking a big risk in telling
> voters that its stimulus plan is working? What will people think
> this winter when markets continue to shrink?
>
> I think the Fed is on the money with deflation

Jul 01 03:28 PM

[harammph:]

Mad Hedge: Get a Hotel room or something. You"ve spent an evening with Janet so many times and told so many about it, that I'm surprised she hasn't told you off by now.

Do you think she'd be pleased?

Jul 04 04:20 AM