Bernanke Faces This-Time-Different Disinflation

Ben S. Bernanke, chairman of the U.S. Federal Reserve
Ben S. Bernanke, chairman of the U.S. Federal Reserve, arrives to testify at a Joint Economic Committee hearing in Washington D.C. Photographer: Brendan Hoffman/Bloomberg

May 7 (Bloomberg) -- The phones started ringing about the time JPMorgan Chase & Co. economists Bruce Kasman and Michael Feroli moved into Bear Stearns’ former Manhattan headquarters in 2008.

“I wish I’d kept a log” of how many people “were just freaking out, calling us nonstop” with questions about the next wave of inflation, said Feroli, the chief U.S. economist. Now the calls have “dried up to a trickle,” he said, even though the Federal Reserve’s balance sheet is close to a record $2.34 trillion and the central bank has left its benchmark interest rate near zero since December 2008.

High unemployment and low inflation -- a combination unprecedented since at least World War II -- will keep Fed Chairman Ben S. Bernanke from raising rates until the second quarter of 2011, Kasman and Feroli say. Their prediction is far later than the November increase forecast by 47 economists in an April 1-8 Bloomberg survey. With the jobless rate above 9 percent since May 2009, workers’ ability to bargain for higher wages has been sapped, along with consumer demand that would allow companies to raise prices.

“The inflation process is going to move slowly,” said Kasman, chief economist and a managing director at JPMorgan Chase, which purchased the failing Bear Stearns two years ago. “The job is to reflate the economy in an environment where there are powerful disinflationary forces. You need a reasonably long period of growth for that.”

Slowest Pace

The Fed’s preferred inflation gauge -- the core personal consumption expenditures price index, which strips out food and energy -- rose at an annual rate of 0.6 percent in the first quarter, the slowest pace since records began in 1959, according to an April 30 Commerce Department report.

Bentonville, Arkansas-based Wal-Mart Stores Inc. cut prices on more than 10,000 items after sales at U.S. stores opened at least a year fell 1.6 percent in the quarter ended Jan. 31, the world’s largest retailer said April 9, adding it plans more reductions.

Home Depot Inc., the largest U.S. home-improvement retailer, lowered prices in March on flowers, fertilizers, lawn equipment and outdoor furniture to help meet its goal of increasing annual sales for the first time in five years.

“We are looking to continue to drive our traffic in the stores,” Craig Menear, executive vice president of merchandising for the Atlanta-based company, said in a March 17 telephone interview. “Things are still difficult out there for customers.”

26-Year High

The jobless rate rose to 9.9 percent in April from 9.7 percent in the first three months of the year. It hit a 26-year high of 10.1 percent in October 2009. The so-called underemployment rate -- which includes people who want work but have given up looking and part-time employees who’d prefer to work full-time -- was 17.1 percent last month, close to October’s 17.4 percent, the highest since the Labor Department began reporting the data in 1994.

The employment malaise is depressing wages. The unit cost of labor, or ratio of hourly compensation to labor productivity, fell at an annual rate of 1.6 percent in the first quarter of 2010, according to the Labor Department. That followed declines of 7.6 percent in the third quarter of 2009, the steepest in more than 60 years, and 5.6 percent in the fourth quarter. With labor costs falling, firms can maintain profit margins without increasing prices.

Different Combination

The combination of low inflation and high unemployment makes this economic cycle different from any since the 1940s, Kasman said. In the recoveries from the recessions of the 1970s and early 1980s, the annual rate of inflation peaked at 10.2 percent and 9.7 percent, as measured by the core personal-consumption index.

During the recoveries in the early 1960s and in 2001, inflation slowed to a pace as low as 1.1 percent and unemployment never rose above 7.1 percent.

Fed officials last week restated their intention to keep their benchmark rate low for an “extended period,” noting that consumer spending continues to be restrained by weak income growth and tight credit. The target for overnight loans among banks has been in a range of zero to 0.25 percent since December 2008.

Minutes of the Fed’s March meeting show policy makers were surprised by the pace at which price growth slowed in the first quarter.

‘Greater Deceleration’

“Participants saw recent inflation readings as suggesting a slightly greater deceleration in consumer prices than had been expected,” according to the minutes, which the Fed released April 6.

Inflation that’s too low raises the possibility of outright deflation and doesn’t ease the real burden of debt, Bernanke said in a 2003 speech when he was a Fed governor. A falling inflation rate also increases real interest rates, effectively tightening monetary policy, he said.

Measures compiled by the Fed’s regional banks show inflation already at record lows. The Dallas Fed’s so-called trimmed mean measure of inflation, which removes the most extreme increases and decreases, fell in 10 of the last 12 months to an annual rate of 1 percent in February and March. The Cleveland Fed’s Median CPI index increased at a 0.6 percent annual rate in March. The index reflects the median change in prices, rather than the weighted average of the traditional consumer price index.

Money Supply

Money supply also points to declining inflation. The broadest measure compiled by the Fed, known as M2, expanded at a 1.5 percent annual rate in March, down from a 9.2 percent rate a year earlier.

“Central banks ignore money at their own peril,” said Gabriel Stein, a director at Lombard Street Research in London. “One of the key signals of threatening deflation is if money supply grows very slowly or in fact contracts.”

Even so, there are signs of life in the economy. The U.S. expanded at a 3.2 percent annual rate in the first quarter following a 5.6 percent pace in the fourth quarter of 2009, the strongest back-to-back performance since the second half of 2003. Employers added 290,000 workers to their payrolls in April, the fourth consecutive gain and the largest since March 2006, according to the Labor Department.

“We’re seeing very soft price pressures right now, but the fact that the economy is expanding at an above-trend pace means we’re going to see price pressures eventually start to turn up as recovery becomes expansion,” said Carl Riccadonna, senior U.S. economist at Deutsche Bank Securities Inc. in New York. He predicts the Fed will begin raising rates in August.

‘Extended Period’

Thomas Hoenig, president of the Fed bank of Kansas City, has dissented three times from the Fed’s “extended period” pledge for low rates, saying at the April 28 meeting that the language limits the Fed’s ability to raise rates “modestly.”

Presidents Richard Fisher in Dallas, James Bullard in St. Louis and Charles Plosser in Philadelphia have also expressed reservations about the promise, citing in part concerns that inflation expectations and medium-term inflation are more likely to be too high than too low.

Expectations currently are for price growth in line with the Fed’s longer-run goal of 1.7 percent to 2 percent. The difference between yields on 10-year Treasury notes and 10-year Treasury Inflation Protected Securities, or TIPS -- a gauge of trader expectations for consumer prices -- was 2.16 percent yesterday. The spread was 1.47 percent on May 6, 2009.

Remain Elevated

The Fed has said the stable inflation expectations, high unemployment and subdued inflation trends warrant continued low rates. Even after two quarters of growth, economists in a Bloomberg survey predict the jobless rate will remain elevated, with the median forecast at 9.6 percent for 2010 and 9 percent for 2011. They estimate inflation will be 1.3 percent this year and 1.45 percent in 2011.

“Inflation data continues to look weaker and weaker,” said Feroli, bolstering JPMorgan Chase’s case for the Fed to hold rates steady for another year. “Were it not for the disinflation, the story would be quite different.”

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