Inflation Risk Is Real: Why You Should Care
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On Friday January 14, the Bureau of Labor Statistics (BLS) released the monthly Consumer Price Index (CPI), which showed a 0.5% increase in the overall price level during the month of December 2010. This equates to an elevated 6.2% annualized inflation rate, which is the highest reading since June 2009. The CPI series is extremely noisy. It is difficult to discern from a single month’s data whether inflation really is accelerating or whether December’s price rise was a one-off event. However, the new CPI number does not come in a vacuum. It is just the latest piece of evidence that inflation risk is much greater than many appreciate and is likely to complicate decision-making at the Federal Open Market Committee (FOMC) in the very near future.
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Over the twelve months ending in December, inflation was up 1.5%. This is a relatively low inflation rate, but presumably right in the middle of the Fed’s preferred range of just under two percent. The problem is that the inflation rate was not constant over the past year; the average annual inflation over the first six months was actually slightly negative, at –0.19%, while inflation over the past six months averaged 3.05%. Over the fourth quarter, the CPI increased at an annualized rate of 3.25%.
Should the Fed be concerned about this increase in the price level? Yes, if for no other reason than it would signal to market participants that departures from the FOMC’s preferred inflation range are treated symmetrically. When inflation was running at 1%, it was a huge source of anxiety for certain members of the FOMC: Chairman Bernanke made clear inflation was running below the desired level in his Boston speech; New York Fed President Dudley emphasized inflation was below the preferred range of 1.75% to 2%; the FOMC policy statement explained “measures of underlying inflation are somewhat low” relative to desired levels; and other commentators harped on the 1% inflation rate representing a 44-year low and a sign of impending deflation. If inflation now remains above the high end of the preferred range and no one says a word, it will signal to market participants that the Fed is much more comfortable losing control of inflation to the upside than it is with the prospect of deflation. The magnitude of the Fed’s reaction to a few months of lower than desired inflation seems to necessitate some reaction to a few months of somewhat higher than desired inflation.
The CPI is not the only metric that suggests inflation risk needs to be closely monitored. The Treasury yield curve and the differential between the nominal and real interest rates suggest that market participants are increasingly worried about the prospect of elevated future inflation. At current rates, the relationship between the yield curves suggests expected annual inflation over the next ten and twenty years of 2.35% and 2.58%, respectively (see above chart). This is slightly above the Fed’s desired range, but generally consistent with stated monetary policy objectives.
The problem is that inflation is not expected to be constant over this period. The forward inflation rates implied by the shape of the yield curve suggest market expectations of sharply accelerating inflation over the next decade. The widening in the gap between the nominal and real yield curves in the previous graph signals an accelerating rate of inflation. While inflation is expected to average 1.96% over the next five years, it is expected to accelerate to 2.51% in five years and 2.97% in seven years, based on semiannual compounding. A forward inflation rate of nearly 3% is a significant psychological barrier. If the Fed allows forward inflation rates to rise above current levels without acknowledgement, it would open the door to the potential for a true unmooring of inflation expectations. In a CNBC interview used to defend quantitative easing, NY FRB President Dudley suggested the Fed has “no desire to fool around with” inflation expectations of 3% precisely because of the difficulty of putting “that genie back in the bottle.”
It would be tragic if the Fed were unwilling to acknowledge the specter of inflation risk out of intellectual stubbornness or personal pique. The Fed seemed to have been caught off-guard by the intensity of the opposition to the second round of quantitative easing (QE2) and launched a media campaign to alter perceptions of what it was doing. In a 2009 interview with 60 Minutes, Fed Chairman Bernanke was refreshingly candid about what the euphemism “quantitative easing” really meant:
“PELLEY Is that tax money that the Fed is spending? BERNANKE It's not tax money. the banks have-- accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed. So it's much more akin to printing money than it is to borrowing. PELLEY You've been printing money? BERNANKE Well, effectively. And we need to do that, because our economy is very weak and inflation is very low.”
Contrast this with Bernanke’s 2010 interview with 60 Minutes:
“BERNANKE One myth that's out there is that what we're doing is printing money. We're not printing money. The amount of currency in circulation is not changing. The money supply is not changing in any significant way. What we're doing is lowing interest rates by buying Treasury securities.”
No one was more responsible for putting the “myth” of money-printing “out there” than Chairman Bernanke, who not only acknowledged that creating electronic reserve balances at member banks was the 21st century equivalent to printing money, but actually sought to advance this interpretation of Fed policy. When it became clear that the public at large was not comforted to learn that the “large scale asset purchases” were financed through debasement of the currency rather than “tax money,” Bernanke decided it was time to hotly contest the “myth” that the Fed’s actions could somehow be misconstrued as printing money. Now, we’re supposed to believe that QE2 is really no different from lowering the fed funds rate.
Neither current nor expected inflation is so elevated that the risks to price stability are obvious. Observers obsessed with inapt comparisons to Japan are likely to point to the low annual inflation rate, downplay any risks presented by forward rates, and may even view the increase in prices as a welcome sign QE2 is effectively reducing the risk of deflation. Those who focus on the (dubious) negative relationships between inflation and unemployment are also likely to underweight the idea that current inflation trends could persist with joblessness so elevated. But if current data are not enough to cause the Fed to rethink QE2 or express some fresh concern about inflation risk, then what data would be sufficient? How high would inflation readings have to go for current policy to be questioned, if not abandoned? And when inflation reaches whatever levels that would elicit a policy response or change, could the Fed even take any credible action then to return inflation to a level consistent with price stability – without triggering another recession? Quite a bit is riding on the answer to these questions.