He earned his chops as an economist by studying the disastrous deflation of the 1930s, he gained some notice by giving advice (mostly ignored) to the Japanese about how to avoid it, and he delivered a memorable speech in 2002 about making sure “it” doesn’t happen here (the very speech that earned him the nickname “Helicopter Ben”).
But now? Bernanke has grounded his helicopter. He’s grown complacent about the prospect of “it” happening here. He’s confident that inflation won’t fall too low, even though the danger is still clear and present.
Bernanke made news Wednesday when he said the Fed would likely begin to reduce the extent of its bond purchases later this year. The winding down of quantitative easing, he said, is dependent on two factors: continued improvement in the labor market and a rise in the inflation rate toward the Fed’s 2% goal.
Bernanke is confident that inflation will climb, but the Fed has been consistently wrong about hitting its inflation target of 2%. The Federal Open Market Committee’s central tendency forecast for inflation in 2013 have been revised lower and lower, meeting after meeting, and now stands at a range of 0.8% to 1.2%. The committee doesn’t foresee getting back above 2% for at least two more years.
That’s extremely low and, in fact, dangerous to the economy. One of the many headwinds keeping the economy down is the low rate of inflation.
We don’t actually have to have a negative inflation rate (deflation) for bad things to happen. Even low levels of inflation can disrupt the normal functioning of the economy because inflation changes the incentives to spend, to invest or to borrow. Why borrow when deflation will make your debt burden larger in real terms? Why spend now when prices will be lower later?
How low is inflation right now?
Here are a few facts:
The Fed would like inflation to average 2% over time, but the inflation rate is 0.74% over the past 12 months and is slowing rapidly, as measured by the personal consumption expenditure price index. Outside of recessionary periods, that’s the lowest rate in more than 50 years. The core inflation rate (excluding volatile food and energy prices) is up just 1.05% over the past year — the lowest rate on record.
Also, the trimmed mean PCE index (which is an alternative way of looking at underlying inflation trends that doesn’t automatically exclude food and energy) fell 0.1% in April. That was its first decline ever.
Inflation expectations are also low and falling. The spread between regular 10-year Treasurys and inflation-protected Treasurys (TIPS) has narrowed. The Cleveland Fed’s analysis shows expected inflation below 2% for the next 30 years. Professional forecasters also expect low inflation to continue.
Is Bernanke correct to believe that inflation rates won’t fall further? At least one of his colleagues, James Bullard of the St. Louis Federal Reserve Bank, isn’t convinced. Bullard voted against the FOMC’s statement on Wednesday because he “believed that the committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings” and issued a statement Friday indicating he had dissented because of a concern about low-inflation risks.
Bernanke was asked at his press conference specifically about Bullard’s perspective: “Does this sort of inflation performance suggest that you should be pushing harder on the accelerator?”
Bernanke hemmed and hawed. He agreed that low inflation is terrible. “It increases the risk of deflation. It raises real interest rates. It means that debt deleveraging takes place more slowly.”
But he stuck to his forecast that inflation would gradually return to 2%. Why?
“There are a number of transitory factors that may be contributing to the very low inflation rate: for example, the effects of the sequester on medical payments, the fact that nonmarket prices are extraordinarily low right now,” Bernanke said. “So these are some things that we expect to reverse, and we expect to see inflation come up a bit.”
Bernanke is partially right: Some of the decline in the rate of inflation is due to temporary factors, such as a big drop in hospital payments. But other factors don’t seem to be transitory at all. It’s not just one or two items that are temporarily depressing inflation. In April, about 43% of prices in the index fell, on everything from gasoline and car rentals to carpets and movie tickets.
One useful way to think about inflation is to categorize prices of goods and services as either sticky or flexible. Sticky prices change infrequently. Think of rents or medical co-payments. Flexible prices, by contrast, change all the time. Think of gasoline or tomatoes.
As you’d expect, flexible prices — which account for about 30% of our purchases — are responsible for almost all of the variation in inflation from month to month. Sticky prices set the tone for future inflation because both buyers and sellers will take their inflation expectations into account when they agree on prices that won’t be changed for a year or two.
Over the past 12 months, flexible prices in the consumer price index are up 0.14%, which means that much of the recent disinflationary trend is due to temporary factors that could be easily reversed. Score one for Bernanke.
But sticky prices are also trending lower. Over the past 12 months sticky prices are up 1.9%, and over the past three months they’re up just 1.5% annualized. Score one for Bullard.
If Bernanke is right about inflation rising toward 2%, then the Fed will certainly begin to cut back on its “QE3” bond purchases. But if Bullard is right about the deflation threat, the Fed won’t taper and might even have to increase the number of bonds it’s buying each month.
That means the inflation data are now the most important numbers determining Fed policy.