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S.F. Fed chief Yellen tells inflationistas to pipe down

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.

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

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com

25 comments

  1. Independent Accountant

    EH:
    There ain't no exit strategy, nor will there be one. Got gold? Get more. Got bonds? Sell, immediately.

  2. DocG

    Yellen is thinking in terms of gradual, systematically developing processes, the same sort of short sighted planning that blinded the big banks to the mortgage crisis until the floor suddenly fell out from under them. What she doesn't consider is the very real possibility of a sudden collapse. And there are many places where catastrophic collapse could take place: the dollar could collapse, the stock market could collapse, the economy of some major country could collapse, consumer confidence could collapse, the demand for Treasuries could collapse, investor confidence could collapse, confidence in money itself could collapse, etc.

    Too many parts of the world economy are being held together with pieces of string. And if any one of these pieces breaks, then all bets are going to be off. We could plunge into a major deflation — or inflation — or, more likely, find ourselves shuttling dangerously from one extreme to the other. To ignore such possibilities and insist that all will be well because everything is once again under control is whistling in the dark. Coming from a government official, it is also the height of irresponsibility. http://amoleintheground.blogspot.com/

  3. frances snoot

    What does Simon Johnson say?
    http://economix.blogs.nytimes.com/2009/05/28/inflation-fears/

    "To talk about imminently increasing inflation in the United States today is to meet with policy makers’ derision. The prevailing thinking among mainstream macroeconomists is straightforward on this point — while unemployment is rising, inflation must be low or even falling. If anything, according to Ben Bernanke and his cohorts, we should fear deflation, i.e., falling wages and prices, a damaging characteristic of the Great Depression in the 1930s.

    But remember, macroeconomic orthodoxy has taken a beating in the past two years. Anyone who claimed subprime mortgages and their ilk could not constitute a macroeconomic threat now has a credibility issue; this includes at least some of our most senior policy thinkers."

    Here are Ms. Yellen's predictions in December 2007 for the upcoming year:
    http://www.frbsf.org/news/speeches/2007/1203.html
    "To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level. However, for the next few quarters, there are signs that growth may come in somewhat lower than I had previously thought likely. For example, some of the risks that I worried about in my earlier forecast have materialized—the turmoil in financial markets has not subsided as much as I had hoped, and some data on personal consumption have come in weaker than expected. I continue to see the growth risks as skewed to the downside in part because increased perceptions of downside economic risk may induce greater caution by lenders, households, and firms."

    Ms. Yellen at least does not maintain, like Bernanke did, that the subprime meltdown would be contained. But Ms. Yellon is extremely conservative in her approach to analyzing the data, predicting that the US would experience
    2.5 percent growth in the year of the Lehman debacle.

    Johnson asks a pertinent question:
    "In all these respects, the United States showed itself to be much more like a middle-income emerging market than the prevailing orthodoxy thought possible. Our financial sector became supersized, took on too much risk, received the mother of all bailouts, and we still struggle to recover from the ensuing instability. What if our inflation dynamics have also changed to become more like those of Argentina, Russia or Ukraine?"

  4. asphaltjesus

    as it sells off assets to soak up liquidity.

    This quote inspires the only Shakespear I know "ay, there's the rub."

    This suggests assets on their books were vetted sufficiently to enable price discovery in the event of a sale. I have doubts about this simple observation.

    Unless, the point is to make it look like it all works when in fact it is likely economic theater.

    Someone enlighten me here.

  5. "DoctoRx"

    A careful reading of the text of Dr. Yellen's speech reveals that she has little fear of severe deflation.

    Her fear is insufficient inflation. She is wedded to 2% inflation forever- which we know means that over time, the real inflation rate will be higher.

    It is therefore unclear why Dr. Harrison says that "deflation should be the Fed’s primary concern right now". 18 months into this depression, core CPI has barely nudged under 2%.

    Given productivity enhancements, modest deflation is just as natural and healthy as modest inflation.

    True price stability should be the Fed's goal, not chronic inflation.

  6. Edward Harrison

    DoctoRx, thanks for your comments. No, we don't have deflation. In fact, because the CPI understates inflation, true inflation is probably even higher than you say. So I agree with you.

    Still, a deflationary spiral is very much a real scenario policy makers should work to avoid. I would argue they could do so by adding fiscal stimulus rather than monetary stimulus, but that's a whole different debate.

    But, the long and short of huge monetary stimulus is excess liquidity which is the definition of inflation. The only reason inflation hasn't shown up in prices is because the money multiplier is dropping as deleveraging occurs.

    As asphaltjesus suggests, this is going to be a problem because the Fed has a bunch of crap assets on its books. I tend to think the Fed's response will be too late and too mild to stop any incipient inflation because they fear wrecking the economy. Add in the mechanics of selling toxic assets and you have a problem.

  7. JEFF

    Would someone please explain to me why inflation is better than deflation?

    Its my understanding that a decrease in the money supply is deflationary and an increase is inflationary. If a decrease causes prices to fall and an increase causes prices to rise, then I'll take deflation every time.

    I know every consumer loves falling prices, but as I business owner (actually I own 2) I love falling prices too. One biz, I've kept prices the same while the other I've increased them slightly compared to last year, but even if I had to lower them as long as my inputs are falling by the same amount or more I'm still ahead.

    The only people that I can tell who benefit from inflation are the people who have access to the money first, i.e the bankers and the wealthy, while the middle class and poor are harmed greatly by inflation. Think GS taking TARP $ using it to drive up the price of oil and unemployed Joe Sixpack now having to pay more for gas!

    I read somewhere that the dollar has lost something like close to 99% of its purchasing power since 1913. I'm not good with math but wouldn't a 2% inflation rate cause the dollar to lose close to 90% over the next 100 years?

    I'm a bit of a history buff and prior to 1913 deflation was quite common and the world didn't end then.

    Again can someone please explain to me as simply as possible why inflation is better than deflation?

  8. Mara

    Indeed, only those who rely upon usury to make their fortunes consider deflation to be a bad thing.

    What's really bad is that the avg worker in this country is experiencing deflation on their wages and home values, while they are not going to experience a deflation in their debt burden or tax burden. There is fast moving inflation on oil prices (again) and I've not noticed food getting any cheaper.

    As for Ms. Yellen, I'm sure she's a lovely person, but she will probably say "all the right things" in anticipation of the impending sacrifice of Ben the Goat Boy. I like the crotchety guy at the Kansas City Fed.

  9. frances snoot

    "But, the long and short of huge monetary stimulus is excess liquidity which is the definition of inflation,"

    Excess liquidity that is moving rapidly through the economy…

  10. RTD

    I posted this on another forum:

    Here's the problem with deflation. Entrepreneurs make investment decisions based upon the difference between the expected return of a new capital investment project and their borrowing costs. The net return must compensate the entrepreneur for opportunity costs and risks.

    Let's assume an environment with 0% inflation and where there are opportunities expected to yield a real return of 6%. Assume entrepreneurs require a real return, net of financing, of 3% to be willing to undertake the project. As long as interest rates are 3% or less, they will undertake the project.

    Now let's introduce 2% inflation into the mix. Assume real returns remain at 6%. Nominal returns will now be 8% (6% real return + 2% increase in prices). Interest rates adjust to include expected inflation and are now 5%. The entrepreneur still gets his 3% return net of financing costs and so undertakes the investment.

    Now let's introduce 2% deflation into the mix. Assume real returns remain at 6%. Nominal returns will now be 4% (6% real return – 2% decrease in prices). Interest rates adjust to include expected deflation and are now 1%. The entrepreneur still gets his 3% return net of financing costs and so undertakes the investment.

    Now let's introduce 4% deflation into the mix. Assume real returns remain at 6%. Nominal returns will now be 2% (6% real return – 4% decrease in prices). Interest rates adjust to include expected deflation but they cannot fall below 0%. At 0% interest rates, returns net of financing are only 2% and so the entrepreneur does NOT undertake the investment. At a deflation rate beyond 6% in this case, returns actually go NEGATIVE. The problem is that interest rates cannot go below zero, so deflation beyond a certain point basically makes capital investment unprofitable. Deflation discourages investment, and lower investment leads to lower incomes which leads to more deflation. A deflationary market is not self-correcting, it is self-reinforcing.

    –RueTheDay

  11. frances snoot

    @Mara:
    The big boys benefit from deflation when they buy up assets for pennies. Win-win-win for those with capital and inside info.

  12. Anonymous Jones

    "Only those who rely upon usury to make their fortunes consider deflation to be a bad thing." Actually it's the other way around. Those with fixed debts consider deflation to be a bad thing. And the existence of fixed debts is the reason deflationary spirals are best avoided. Don't focus on the price level too much.

    Also, on a tangential point, beware when tossing around "those who rely upon usury." That includes everyone with a pension invested in bonds. That includes everyone who has purchased a life insurance policy. It includes pretty much every saver in the economy…

  13. frances snoot

    http://www.safehaven.com/article-13725.htm

    "Now we mention it again: hyperinflation. So is it a real threat? The simple answer is: it depends on how the dynamics play out. What we do know is that all hyperinflation in the world has started when a country's central bank prints money to finance government spending. The Fed adamantly denies that that is what it is engaged in, but when something looks like a duck, swims like a duck, quacks like a duck, we call it a duck. We intentionally use such strong language to send a strong signal that the policies pursued, in our view, are reckless and
    dangerous."

  14. JEFF

    @ RTD,

    Not every business borrows money.

    The problem is an over investment or malinvestment as the Austrians call it in many areas of the economy. As you said deflation discourages investment, but the last thing we need right now is more investment in homes, strip malls, fast food joints, nail salons, car dealers, etc…

    So this is good, as Murry Rothbard said "deflationary credit contraction greatly helps to speed up the adjustment process, and hence the completion of business recovery". See full article here: http://mises.org/story/309

    Thus, I respectfully disagree with you about deflation NOT being self correcting. If the gov't would stop trying to prop up asset prices and just let prices fall eventually savers will see bargains and start bidding up the price of assets and a recovery would occur.

    Frank Shostak writes "[d]eflation is the beginning of the process of economic healing. Deflation arrests the process of impoverishment inflicted by the prior monetary inflation. Contrary to mainstream thinking then, deflation of the money stock strengthens the producers of wealth, thereby revitalizing the economy". Full article here:http://mises.org/story/309

  15. RTD

    Jeff – Every business has a cost of capital, and for most large businesses debt financing is a substantial part of that.

    The problem with Austrian Capital Theory is that it's only half of a capital theory – it only looks at the asset side of the equation and ignores the liability structure side. It's implicitly assuming that business investment is primarily financed internally via retained earnings. This simply isn't true in a modern capitalist economy. Minsky's capital theory is far more in line with reality than that of the Austrians.

    –RueTheDay

  16. JEFF

    @ RTD,

    I was just pointing out in your example you implied that all businesses borrow money this is not true, yes a lot do, but some don't. Believe me I understand the cost of capital as I've been part owner of a handful of private companies during my lifetime.

    Don't know much about the Austrian Capital Theory or Minsky's either. But, what I do know is that deflation is not the evil most claim it to be and inflation is much more sinister than most admit. Which is the point of my post.

    You claimed that the problem with deflation is its NOT self-correcting to which I call bullsh!t. There are many savers like me who have plenty of cash and are patiently waiting on the sidelines for prices to clear.

    Savers will step in and buy assets; businesses and homes when it makes economic sense to do so. When businesses are allowed to fail the excess capacity is removed allowing surviving businesses to prosper.

    Like I said deflation was quite common prior to 1913 and we survived. Instead of propping up failed businesses while trying to inflate another bubble we need to embrace deflation to cleanse the system to allow the savers to reinvigorate the economy.

    I strongly suggest you read Murry Rothbard's "America's Great Depression" Bush and now Obama are making the same mistakes Hoover did to make the situation worse, its quite eerie.

  17. Greg Hall

    In light of globalism, Prof. Yellen is correct…inflation is not only not a worry, but likely to revert to a greater deflation due to the extent of debt. It's wonderful to buy distressed assets at rock bottom, yet if there's zero cash and little buying power around, it's a long-term [stagflation] hold.

  18. redst8r

    @Jeff
    Thanks for your response regarding the "benefits" of deflation. I too am a saver and business owner. I am sitting on cash (and have for several years) waiting for the opportunity that I believed was overdue. I expect there are a lot of "quiet folks", large and small that are doing the same. Count me as a deflation proponent. It is part of the natural economic cycle and is long overdue.

    @Anonymous Jones
    With respect I believe "usury" refers not to pensioners or bond owners but to those who rely on over high interest rates. Even so, "usury" practitioners are not the biggest beneficiaries of inflation. The Federal and State governments gain the most. The various governments rely on inflation as a hidden tax increase while the cheaper dollar benefits them as they are collectively the largest debtor(s) in the world.

  19. VG Chicago

    >>> 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.<<<

    Please allow Vinny to explain this in laymen terms even he can understand: "We'll do all that we can to keep chumps' salaries low, while we'll print money in ever increasing quantities, which, of course, we will swiftly steal."

    Vinny GOLD — "a regular, no BS kinda guy"

  20. VG Chicago

    DocG: "We could plunge into a major deflation — or inflation — or, more likely, find ourselves shuttling dangerously from one extreme to the other."

    That sounds like Economic Bipolar Disorder. Nasty! I just saw a bipolar patient, and let me tell ya, she ain't no fun! She almost ruined my day. I better double her fees right away…LOL

    Vinny

  21. C.F.

    I am not a young man. I have never seen one of these "deflationary spirals". I suspect there is no such thing.
    Persistent inflation, oth, seems as certain as death and taxes.

  22. JEFF

    @ redst8r:

    You're welcome and amen, brother!

    IMHO this whole talk of a deflationary death spiral is propaganda by banking elite so they can continue to loot common citizens legally through inflation.

  23. Aki_Izayoi

    "I know every consumer loves falling prices, but as I business owner (actually I own 2) I love falling prices too. One biz, I've kept prices the same while the other I've increased them slightly compared to last year, but even if I had to lower them as long as my inputs are falling by the same amount or more I'm still ahead."

    No, no, they do not.

    "The problem is, as is intuitively obvious to any laid-off factory worker who has contemplated the cheap knick-knacks on sale at Wal-Mart, that the drop in cost of living never matches the drop in wages. Like many free-trade arguments, it is qualitatively true but quantitatively false. The mitigating factors mitigate; they just don’t mitigate enough.

    Don't believe this? Let's count up how many people have voted against incumbents because they were unemployed, and compare this to how many have done so because they couldn't buy a pair of scissors for $.99. Has there ever been a demonstration in the streets about the latter?"

    http://www.ianfletcher.org/things_fall_apart.htm

    "The problem is an over investment or malinvestment as the Austrians call it in many areas of the economy. As you said deflation discourages investment, but the last thing we need right now is more investment in homes, strip malls, fast food joints, nail salons, car dealers, etc…
    "

    This deflation will not lead to any healing. I really dislike the position that deflation is a normative good. However, I do not see more asset inflation being desirable either. It is best to engineer a slow-roll deflation where the harms (such as unemployment and inability for some people to pay for health care and other services). Give up the search for economic "prosperity" and economci growth; an increase GDP would not increase happiness above a certain threshold. Better to think like a Popperian piecemeal engineer and deal with human suffering instead of trying to aim for "prosperity."

    I do not think this deflation will self correct. There is really nothing to invest in even after the delevering is complete except perhaps political manipulated emerging markets.

    I think some forms of "malinvestment" as desirable… Bryan Caplan says that we have a "make-work" bias, and I suppose the reason for this bias is that jobs = income (for most people), and it gives people something to do. I do not see any other way to give unskilled labor good jobs except make-work jobs (which Austrians deem as a form of "malinvestment") and other forms of "malinvestment" such as nail salons.

    And why don't you buy stocsk right now with your savings? Hasn't the market "cleared" already for that asset class? The prices reflect the market clearing price; that an equilibrium where seller and buyer agree on a single price to conduct their transactions. And you should buy real estate now if you actually believe the hyperinflationist rhetoric.

  24. JEFF

    @ Aki_Izayoi you said:

    "It is best to engineer a slow-roll deflation…"

    So you agree that deflation is better than inflation.

    Regarding "cheap knick-knacks", I don't understand what you're talking about you're either making this more complicated than it is or assumed I said things that I did not.

    My point is strictly about consumers and businesses, people prefer paying less for goods with everything else being equal. I've never met a consumer who would knowingly prefer paying $4.99 for a pair of scissors when the same identical pair can be bought for $0.99. To test this "theory" go ask anyone on the street "Would they rather pay $5 a gallon for gas or pay $1 with everything else being equal?"

    So, you believe as RTD does above "Deflation discourages investment, and lower investment leads to lower incomes which leads to more deflation. A deflationary market is not self-correcting, it is self-reinforcing."

    Then you and RTD must believe prices of goods would just continue to fall eventually collapsing to ZERO since its self-reinforcing and nothing to stop it.

    Let me know when people can buy farmland, ocean front land, Porsches, Maseratis, Rolex watches, diamond rings, well you get the idea, for $0.00.

    Trust me, when prices get low enough savers like redst8r above will step in and support prices.

    I disagree with your comment "There is really nothing to invest in even after the delevering is complete."

    There are plenty of things to invest in at the right price. Though right now I'm using my savings to short stocks which currently are quite expensive:

    http://zerohedge.blogspot.com/2009/06/is-market-pricing-in-2012-forward.html

    So, no I don't think the market has ultimately cleared this is just a bear market rally, but when stock prices get cheap then yes, I'll be buying aggressively. Even with deflation the stock market is NOT going to zero.

    I'm a deflationista, so I think real estate prices will fall further, but eventually I'll be buying a condo here in Vegas once the prices bottom out and I'll bet you any amount of money that Strip property will bottom above $0.00.

    BTW, malinvestment while unavoidable is NOT desirable at any level because it misuses capital. Think of all the capital that was wasted on homes which are really just shelter. Our country would've been much better off if this capital went into say health care, infrastructure, technology or alternative energy.

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