Inflation or deflation? Phil. Federal Reserve Bank President says “Inflation”

Thursday, December 3rd, 2009 | Economics |

Monetary Policy and the Wisdom of Wayne Gretzky:

Ultimately, inflation is a monetary phenomenon and there is no question that current monetary policy is extraordinarily accommodative. The Federal Open Market Committee has maintained the federal funds rate near zero for just about a year now and the Fed has more than doubled its balance sheet in the process. Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available to the economy, the inflation rate is likely to rise to levels that most would consider unacceptable. The great challenge facing the Fed is getting those “appropriate steps” right.

The task is made more difficult, in part, by competing views of the economic forecast and the underlying structure of the economy driving that forecast. One commonly held view is that the economy is very weak now and, more important, that during the economic recovery, high rates of unemployment and very low rates of resource utilization will prevent inflationary pressures from arising for quite some time, perhaps years. This perspective suggests there is no danger that excess liquidity will generate inflation in the foreseeable future. According to this view, the Fed need not worry about withdrawing the liquidity or raising rates anytime soon because the inflation forecast will remain quite tame.

An alternative view shared by many others is that the just-described conventional wisdom misses the mark and without a more deliberate policy of reducing liquidity and raising interest rates sooner rather than later, we could very well see inflation become a serious concern. In this view, inflationary expectations play an important role in the dynamics of inflation. It is the Fed’s credibility to keep inflation low and stable that is key to anchoring those expectations. So, the Fed must act in a way that assures the markets and the public that it will take the necessary steps to keep inflation low and stable. If it does not do this, expectations can become unanchored and inflation will rise regardless of the amount of unemployment in the economy.

This view is consistent with both theoretical and empirical evidence that finds that economic slack or low resource utilization is not a very reliable predictor of inflation. Moreover, several empirical studies have shown that economic slack is difficult to measure with any accuracy. So making policy decisions based on measures of such slack and particularly on forecasts of slack many quarters ahead becomes problematic. Indeed, the failure to act in a way that keeps expectations of inflation anchored can easily trump economic slack in determining the path of inflation. Recall that some of the highest inflation rates this country has seen in the post-World War II era occurred in the late 1970s when we had high rates of unemployment and low resource utilization.

Previously - Inflation or deflation? Chris Martenson: “Should be massive, self-reinforcing deflation, but it isn’t”

Tags: inflation, the fed