Bernanke Bond Buying May Risk Rise in Prices Similar to 2004

The Federal Reserve may be underestimating the inflation outlook for the second time in less than a decade as it prepares to pump more money into the U.S. economy.

The Fed today will probably restart purchases of bonds to spur the economy even as growth is likely to accelerate at a 2.6 percent annual pace in the second quarter of next year from 2 percent last quarter, according to Bloomberg News surveys of economists. The Fed will likely pledge to buy $500 billion or more in securities, according to 29 of 56 economists surveyed.

By expanding Fed assets, Chairman Ben S. Bernanke may go down the same policy path taken in 2003-04, when he and other central bankers kept rates near a record low as inflation rose faster than initially measured. Bernanke may risk increasing expectations for higher inflation by too much, causing a shake- up in currency and bond markets, said James D. Hamilton, a University of California, San Diego economist.

“That perception alone would bring about a series of immediate challenges, such as a rapid flight from the dollar, commodity speculation and possible under-subscription to Treasury auctions,” said Hamilton, a former visiting scholar at the Fed board and the New York and Atlanta district banks. “So the Fed has a careful tightrope act here.”

By 2012, the unprecedented stimulus would probably cause inflation excluding food and energy to exceed 2 percent, beyond the Fed’s preferred range, according to seven economists surveyed, including Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut.

‘Maximum’ Panic

“The parallels are very close to 2003, when the Fed had a maximum degree of panic about deflation when inflation had already bottomed out and was about to pick up,” said Stanley, a former Richmond Fed researcher who expects 2.8 percent inflation in 2012 on a rise in the prices for commodities and housing. “Their inflation forecasts are going to be too low, and as a result policy is going to be very easy.”

The Fed would probably not be alone in underestimating inflation. From 1996 until 2009, the Bureau of Economic Analysis revised up its initial reports on core inflation by an average of 0.21 percentage point, according to James Stock, a Harvard University economist.

Policy makers are scheduled to release a statement at around 2:15 p.m. in which they’ll likely reiterate the view from their September release that “inflation is likely to remain subdued for some time,” said former Fed governor Lyle Gramley, now senior adviser at Potomac Research Group in Washington.

Too-Low Inflation

Any “bad shocks” could tip the U.S. into “a deflationary trap with low investment, high real rates of interest and slow productivity growth because of slow capital formation for extended periods of time and slow job growth,” Stock said in an interview with Bloomberg Television’s “InsideTrack.”

“That is a terrible situation,” he said. If the Fed “takes too much action, we find ourselves with 2.5 percent or 3 percent inflation and the economy really takes off.”

Treasuries rose today, sending the yield on 30-year bonds five basis points lower to 3.874 percent as of 11:03 a.m. in New York. Two-year notes yielded 0.343 percent, and the yield on the 10-year note fell five basis points to 2.532 percent.

The Treasury market is pricing in lower inflation expectations than it should, said Michael Pond of Barclays Plc.

“The market is looking for too-low inflation even though we won’t get a ton,” Pond, co-head of interest-rate strategy at Barclays in New York, said yesterday in a radio interview on “Bloomberg Surveillance” with Tom Keene.

Trader Expectations

The difference between yields on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for the annual increase in consumer prices over the life of the maturity, increased yesterday to 2.21 percentage points, the widest level since May 18.

Bernanke as a central bank governor in 2003 urged colleagues to avert a drop in prices amid sluggish job growth, according to transcripts of a May 2003 meeting released last year. The central bank kept its target rate at 1 percent for a year beginning in June 2003 to counter deflation.

Meanwhile, inflation excluding food and energy rose from an initially reported 1.2 percent in May 2003 to above the Fed’s 2 percent goal a year later. An initial reading of 1.6 percent for May 2004 is now 2.1 percent in the history books.

Since December 2008, the Fed has kept interest rates near zero and used asset purchases to try to stimulate growth following the worst recession since the 1930s. New asset purchases would follow Fed acquisitions of $1.7 trillion in Treasuries and mortgage debt that ended in March.

Inflation Slowed

Even with unprecedented stimulus, the economic recovery and inflation have slowed. The Fed’s preferred price measure, which excludes food and fuel, rose 1.2 percent in September from a year earlier, the smallest gain since September 2001. Most Fed officials’ long-term preferred range for the inflation rate is about 1.7 percent to 2 percent.

Passing on higher costs isn’t feasible for some companies. Domino’s Pizza Inc. will keep its promotion of two medium pizzas for $5.99 each, Chief Executive Officer Patrick Doyle said on an investor call last month. “We’ve got to provide the price that’s going to get consumers to buy,” he said.

Still, signs of inflation are emerging. Oil prices have risen 18 percent since May, and food staples including corn and cattle are up more than 20 percent this year.

Wal-Mart Stores Inc.’s U.S. stores chief Bill Simon, during an investor meeting last month in Bentonville, Arkansas, predicted “a slightly inflationary environment in our food business.”

Market Tightening

While apartment rents, a component of core inflation, rose less than 1 percent in the third quarter, the market is tightening as vacancies dropped for the first time in three years, Reis Inc. said Oct. 6.

“The housing situation is something that could turn around pretty quickly if we actually had any kind of job growth,” said Chuck Lieberman, chief investment officer at Advisors Capital Management LLC in Hasbrouck Heights, New Jersey.

Some investors have bet prices will rise. The U.S. Treasury Department Oct. 25 sold $10 billion of five-year Treasury Inflation Protected Securities at a negative yield for the first time at a U.S. debt auction. The securities drew a yield of negative 0.55 percent.

“The real ugly question is, will this ultimately end up being inflationary?” said Scott Minerd, the Santa Monica, California-based chief investment officer at Guggenheim Partners LLC, who helps oversee $76 billion. “In the long run, five to 10 years from now or in the next decade, this is going to be a massive problem.”

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net Scott Lanman in Washington at slanman@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

Enlarge image

Ben S. Bernanke, chairman of the U.S. Federal Reserve

Andrew Harrer/Bloomberg

Ben S. Bernanke, chairman of the U.S. Federal Reserve.

Ben S. Bernanke, chairman of the U.S. Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Nov. 3 (Bloomberg) -- Former Federal Reserve Governor Randall Kroszner talks about the need for U.S. central bankers to keep deflationary expectations from taking root, and the effects of yesterday's midterm elections. Kroszner speaks with Sara Eisen in Chicago on Bloomberg Television's "In the Loop." (Source: Bloomberg)

Nov. 3 (Bloomberg) -- David Stockman, a former budget director in the Reagan administration, talks about about the outlook for the U.S. economy and tax policy following yesterday's midterm election. Stockman speaks with Erik Schatzker and Deidre Bolton on Bloomberg Television's "Inside Track." (Source: Bloomberg)

Nov. 3 (Bloomberg) -- James Grant, editor of Grant's Interest Rate Observer, talks about the outlook for today's Federal Reserve decision. The central bank today will probably restart purchases of bonds to spur the economy even as growth is likely to accelerate at a 2.6 percent annual pace in the second quarter of next year from 2 percent last quarter, according to Bloomberg News surveys of economists. Grant speaks with Margaret Brennan on Bloomberg Television's "InBusiness." (Source: Bloomberg)

Nov. 3 (Bloomberg) -- Shawn Matthews, chief executive officer of Cantor Fitzgerald & Co., talks about the potential impact of additional debt purchases by the Federal Reserve on the economy and the outlook for the bond market. Matthews, speaking with Suzanne O'Halloran on Bloomberg Television's "InBusiness With Margaret Brennan," also discusses the outlook for Cantor's growth and hiring plans. (Source: Bloomberg)

Nov. 3 (Bloomberg) -- Allen Sinai, chief global economist at Decision Economics, discusses the outlook for Federal Reserve monetary policy following yesterday's midterm elections. The Federal Reserve is expected to announce plans to resume large-scale purchases of securities in a bid to boost economic growth and employment, according to 53 of 56 economists surveyed by Bloomberg News last week. Sinai speaks from Boston with Betty Liu on Bloomberg Television's "In the Loop." (Source: Bloomberg)

Nov. 3 (Bloomberg) -- James Stock, a professor at Harvard University, discusses expectations for inflation and the outlook for Federal Reserve monetary policy. Stock talks with Erik Schatzker on Bloomberg Television's "InsideTrack." (Source: Bloomberg)

Nov. 3 (Bloomberg) -- Brendan Brown, chief economist at Mitsubishi UFJ Securities International Plc, talks about the U.S. economic recovery and the outlook for a second round of the Federal Reserve's quantitative easing program. He speaks with Maryam Nemazee on Bloomberg Television's "Countdown." (Source: Bloomberg)