Deflation, Not Asset Price Bubbles

by: Tim Duy

I see Mark Thoma links to Martin Feldstein. I think it is worth quibbling with this statement:

Monetary and fiscal policies cannot be expected to turn this situation around. The US Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero; but, given a fear of asset-price bubbles, it will not reverse its decision to end its policy of buying Treasury bonds – so-called “quantitative easing” – at the end of June

I don't believe this is technically correct - it is not fear of asset bubbles that is the primary driver of Fed policy. To be sure, the Fed is a little more cautious about the potential damage that may result from asset bubbles. Federal Reserve Governor Janet Yellen identified the possibility of such bubbles emerging, and may inded be wary to throw more fuel onto that fire.

That said, the issue of deflation, or, more specifically, lack of deflation, is the primary reason the Fed is likely to hold its ground. I think Federal Reserve Chairman Ben Bernanke made this pretty clear in his most recent press conference. You could argue that any existing inflation is actually the by-product of asset-price bubbles, particularly in commodities, but again, this is not likely the determining factor for the Fed. More likely is that with downwardly rigid wages, a much more severe downturn is likely required to rekindle fears of wage deflation. With the economy even limping along, wage growth will tend to be positive, and that will likely keep deflation at bay, Similarly, a weak labor market imposes the counteracting force, preventing a true wage-price inflation spiral from developing.

In any event, the Fed is out of the game, barring of course the usual suspects - a sharp downturn in activity and/or fresh financial crisis.