Bernanke Joins King Tolerating Inflation
Inflation flashing red may be less of a green light for higher interest rates as global growth falters.
Some Federal Reserve policy makers favor keeping their benchmark rate close to zero until price increases reach a level Vincent Reinhart, a former top official, says could be 3 percent. The Bank of England has held its key rate at a record low even as U.K. inflation breached its 2 percent target for 21 months. Brazil executed a surprise cut Aug. 31 to safeguard its economy even after inflation quickened to a six-year high.
Policy makers such as Fed Chairman Ben S. Bernanke and Bank of England Governor Mervyn King may be challenging central-bank orthodoxy to replenish depleted toolkits and support recoveries at risk of sliding back into recession. Tolerating higher inflation may make long-term Treasuries less attractive while supporting stocks and commodity prices, said Jim Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds.
“There’s a hint of desperation here,” said Kochan, who helps manage $216 billion in Menomonee Falls, Wisconsin. “They’re clearly concerned that monetary policy to date hasn’t really accomplished what they expected it to. So they ask themselves, why? And what could we do about it?”
If adopted, the strategy might be called “Generate Inflation Now,” or GIN, Reinhart said, a reversal of the Ford Administration’s “Whip Inflation Now,” or WIN, program in the 1970s.
“Everybody knows high inflation is bad,” said Reinhart, the Fed’s director of monetary affairs from 2001 to 2007 who will become Morgan Stanley’s chief U.S. economist in October. “Nobody is sure of where the cutoff is.”
Bernanke and his Federal Open Market Committee gather tomorrow in Washington for a two-day meeting and will issue a statement Sept. 21 at 2:15 p.m. New York time. Some economists anticipate additional stimulus aimed at reducing long-term borrowing costs and boosting growth. The Fed cut the target for its benchmark federal funds rate almost to zero in December 2008 and has since purchased $2.3 trillion of bonds.
The FOMC at its Aug. 9 meeting considered conditioning its pledge to keep interest rates at record lows “on explicit numerical values for the unemployment rate or the inflation rate,” according to minutes released Aug. 30. The commitment should be contingent on joblessness falling to around 7 percent or 7.5 percent as long as inflation stays below 3 percent in the medium term, Charles Evans, president of the Federal Reserve Bank of Chicago, said in a Sept. 7 speech.
Focus on Core
Unemployment was 9.1 percent in August, and the Fed’s preferred inflation gauge, which excludes volatile energy and food prices, rose 1.6 percent in July. Policy makers should focus on core inflation to better reflect trends that are “likely to be sustained over the medium term,” the International Monetary Fund said in a chapter of its World Economic Outlook released Sept. 14, ahead of its annual meeting of central bankers and finance ministers this week.
Columbia University’s Michael Woodford and Harvard University’s Kenneth Rogoff are among proponents of faster price increases, which should result in lower interest rates adjusted for inflation. This might stimulate spending, along with a side- effect of helping pare record debt loads.
While computer simulations imply this strategy will work, it’s untested in the real world, said Woodford, a professor who co-taught economics with Bernanke at Princeton University. There has been “nervousness” among central bankers about saying “you would allow inflation,” he said. Now “there’s at least more willingness to discuss the issue.”
Consumer prices worldwide may rise at a slower pace after jumping earlier this year as faltering economic growth drags down food and energy costs. JPMorgan Chase & Co. (JPM) economists estimate inflation in developed markets will average 1.3 percent in the second quarter of 2012, down from 2.7 percent in the same period this year.
The Fed should get U.S. prices back to the path they were on before the September 2008 collapse of Lehman Brothers Holdings Inc., Nobel laureate Roger Myerson at the University of Chicago said Aug. 23 on Bloomberg Television.
According to Bloomberg calculations, the central bank would need to generate annual inflation of 3.3 percent in the two years through July 2013 to return to a hypothetical 2 percent path since July 2008, under the Commerce Department’s personal- consumption-expenditures price index. This gauge rose 2.8 percent in July from a year ago.
Changing policy to tolerate higher inflation means lower bond prices in the long run and weaker developed-market currencies, including the dollar and pound, against emerging markets, said Stephen Jen, managing partner at SLJ Macro Partners LLP in London.
Wells Fargo’s Kochan and Pacific Investment Management Co.’s Anthony Crescenzi agree bond prices would suffer. If the Fed successfully implemented this strategy and European officials managed to contain the continent’s sovereign-debt crisis, two-year yields, which traded at a record low of 0.1512 percent today, might be little changed, while 10-year rates increased to a range between 3 percent and 4 percent within two or three years, said Crescenzi, who helps manage $1.3 trillion as executive vice president at Pimco in Newport Beach, California.
Yields on 10-year Treasuries were at 1.99 percent at 9:56 a.m. in London today. U.S. debt was the best-performing asset class in August as bond investors ignored Standard & Poor’s Aug. 5 decision to strip the U.S. of its AAA rating. Treasuries returned 2.8 percent, while the global bond market gained 1.99 percent, Bank of America Merrill Lynch index data show.
Crescenzi cautions that faster inflation may not produce the economic benefits proponents project, instead reducing the amount of goods and services households and businesses could buy. That would cut production -- and eventually incomes.
“It would turn a virtuous cycle into vicious,” he said. “I see it as quite negative.”
Central banks with a target also may have to squelch price increases later, risking harm to growth and “a serious disinflation,” said Raghuram Rajan, former IMF chief economist and a professor at the University of Chicago’s Booth School of Business.
More than 20 central banks have adopted some type of inflation target since the Reserve Bank of New Zealand pioneered the strategy two decades ago. Such targets help control expectations of future price pressures and provide clarity about the direction of interest rates.
Failed to Prevent
The strategy nonetheless took a hit for failing to anticipate or prevent the worst economic crisis since the Great Depression. In the future, inflation targets should be coupled with a tool that helps deliver financial stability, a report sponsored by the Brookings Institution said last week.
The Bank of England has left its benchmark rate at 0.5 percent since March 2009. While inflation may reach 5 percent in the next few months, it might have been below the bank’s 2 percent target without temporary shocks such as this year’s oil- price spike, King said in an Aug. 15 letter to Chancellor of the Exchequer George Osborne.
Any change at the Fed would face opposition at the U.S. central bank, where policy makers favor a long-run inflation goal of 1.7 percent to 2 percent, according to their most recent economic projections in June.
Richard Fisher, president of the Federal Reserve Bank of Dallas, told reporters Sept. 12 he couldn’t imagine trying to explain the shift to unemployed workers and others “who don’t want their income or meager savings eroded by price increases.” He was one of three officials to dissent from the August decision to keep rates near zero through at least mid-2013.
Of 27 central banks Morgan Stanley monitors with formal or informal targets, 15 now face inflation running above their aim. Some emerging-market officials may be sacrificing their goal to support economic growth or financial stability, Peter Attard Montalto, an economist at Nomura International Plc in London, said in a Sept. 12 report that identified Turkey and Hungary.
Brazil cut its benchmark rate to 12 percent on Aug. 31 as consumer prices rose 7.23 percent from a year earlier. While the increase exceeded the 6.5 percent upper limit of the bank’s target range for a fifth straight month, officials remain committed to the policy and price increases will start to ease, President Alexandre Tombini, said Sept. 8.
Among developed countries, the European Central Bank has proved less tolerant of faster price increases -- a legacy of Germany’s hatred of the inflation often blamed for weakening democracy in the 1920s and aiding Adolf Hitler’s rise to power.
The Frankfurt-based central bank, which aims to keep inflation just below 2 percent, raised its benchmark rate twice this year, to 1.5 percent, even as the Greek-led debt crisis threatened expansion. With economies slowing, President Jean- Claude Trichet said Sept. 8 that price risks are “broadly balanced” in the medium term, despite inflation at 2.5 percent in August.
More central banks may make similar efforts to “explain away” the temporary nature of inflation as a reason to ignore it, said Jen, a former IMF economist. Policy makers “will put more emphasis on growth,” he said.