Submitted by Edward Harrison of Credit Writedowns.
Of late, there have been a lot of worries about he 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 a 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.
Bu, it is clear that Yellen thinks the Fed should err on he 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.
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