Where’s the inflation? Ever since the Federal Reserve Board embraced quantitative easing and other extraordinary measures, critics have charged that rapid inflation was just around the corner. The alarmist calls to worry seem reasonable. A generation of investors has been tutored by Wall Street research that the classic explanation of inflation is “too much money chasing too few goods.” Worse yet, it doesn’t take much imagination to think that the Fed’s historic push on the monetary accelerator could ignite uncontrollable inflation, evoking shades of Germany in the 1920s and Zimbabwe in the 2000s (or prices quadrupling during the Continental Congress of 1775 and 1780).
Yet inflation is dormant. The Consumer Price Index was unchanged for July, and over the past 12 months it has risen at a 1.4 percent annual rate, according to the Bureau of Labor Statistics. That’s well below the Fed’s target range of 2 percent. Even more striking are forward-looking measures of inflation. The gap between nominal 10-year Treasury yields and the yield on 10-year Treasury Inflation Protected Securities says investors anticipate consumer price inflation will average about 2 percent over the next 10 years. A model of inflation expectations developed at the Federal Reserve Bank of Cleveland predicts the inflation outlook may be even better. The model matches inflation expectations from three sources—the Blue Chip forecasts, the Survey of Professional Forecasters, and inflation swap derivatives. The latest reading of 10-year expected inflation is 1.26 percent. “The numbers are all pretty consistent,” says Joseph Haubrich, economist at the Cleveland Fed. “They’re all pointing toward relatively low inflation.”
What gives? For one thing, a global financial flight from Middle East turmoil, the ongoing European debt and currency crisis, the slowing Chinese economy, and other troubling developments have pushed down the yield on safe-haven U.S. Treasuries. For another, price pressures remain contained during a weaker-than-expected recovery with lingering high unemployment. Indeed, it’s underappreciated how the Fed’s unconventional actions have shored up the overall price level. “I think the main effect of the Fed’s actions to date has been to help prevent deflation, which would be an outright decline in wages and prices,” says James Hamilton, economist at the University of California in San Diego.
Thing is, more money flooding the system doesn’t always lead to corrosive and cumulative increases in inflation rates. Sometimes it does, and sometimes it doesn’t. You should see lower unemployment and faster economic expansion before the effect of money growth starts showing up as inflationary pressure. Investors seem confident the Fed at that point has adequate tools to contain inflation. “Inflation might still become a problem, but it would be a manageable one, and certainly much preferable to an economy sunk for decades in recession and deflation,” writes Mark Zandi, chief economist at Moody’s Analytics and author of the forthcoming book, Paying the Price: Ending the Great Recession and Beginning a New American Century.
Most important, the inflation optimism reflects an even bigger bet than a careful judgment of central bank technical expertise. The global capital markets—which includes everyone from 401(k) savers to Chinese flight money—is gambling that history will repeat itself or, at the very least, rhyme. That’s the unmistakable conclusion in a new biography of Paul Volcker, the dedicated public servant and legendary head of the Fed from 1979 to 1987. Volcker is best known for standing tall against the escalating inflation of the 1970s, laying the foundation for some three decades of disinflation and price stability. “The U.S. Federal Reserve has a record of reigning in inflationary pressures, thanks to Volcker,” says William Silber, author of Volcker: The Triumph of Persistence.
Silber persuasively argues that the foundation of Volcker’s successful strategy in combating inflation was the insight that good monetary policy was only possible with sound fiscal policy. “Volker refused to monetize the debt,” says Silber, also a professor of finance and economics at the Stern School of Business at New York University. In other words, Volcker refused to accommodate the Reagan-era budgets deficits. “It forced Congress to reign in the deficit to avoid exorbitantly high real interest rates.”
It worked. A series of Congressional reforms and presidential initiatives from Reagan to Clinton gradually nudged the federal budget into surplus by 1998. (One of my favorite lines from the book is Silber’s observation that: “Volcker promoted the goal of fiscal integrity that Ronald Reagan promised to the American people, turning Reagan into Reagan.”) Of course, we all know the budgetary gains were subsequently squandered.
So the first part of the inflation-optimism gamble is that Congress and the White House will put the federal government’s debt and deficit on a more sustainable path once the bitter election is over. Put aside campaign rhetoric for the moment: Washington is embracing smaller government. It’s a theme that runs through the Obama administration’s budget, Republican vice-presidential candidate Paul Ryan’s blueprint, the plan outlined by Alan Simpson and Erskine Bowles—co-chairmen of Obama’s deficit-reduction commission—and several other bipartisan proposals. (This isn’t to say the presidential election is a case of voting for Tweedledee or Tweedledom. No, there are real differences in the budgets, particularly over deciding who will bear the brunt of fiscal conservatism.)
Inflation optimists are also betting that the Fed learned from Volcker that sound fiscal and sound monetary policy feed off of and reinforce one another. The Fed can’t let Washington off the fiscal hook by winking at high and rising inflation, the “primary magic potion that policy makers have always applied in such a predicament,” says Bill Gross, co-founder and co-chief investment officer of the mutual fund giant Pimco. Well, it was the primary magic potion until Volcker came along.