Bernanke Ponders ‘Crapshoot’ Amid Deflation Risk

Chairman of the U.S. Federal Reserve Ben S. Bernanke
Chairman of the U.S. Federal Reserve Ben S. Bernanke gives a speech on monetary-policy tools today. Photographer: Kevin Lorenzi/Bloomberg.

Federal Reserve Chairman Ben S. Bernanke once advocated setting an inflation target to keep prices from rising too fast. Now he may get the Fed to adopt a target to keep the inflation rate from falling.

Minutes of the Fed’s Sept. 21 meeting showed policy makers discussed “providing more detailed information about the rates of inflation” that officials consider consistent with stable prices and maximum employment. The objective would be to boost inflation expectations and stimulate the economy, the minutes said. Bernanke said today that inflation is too low and that the Fed could modify its statement to signal interest rates will stay low for longer than investors expect.

Announcing an inflation goal as a way to accelerate rather than slow price increases has a scant track record outside of Japan’s efforts to beat deflation over the past decade. Fed officials are considering the move alongside a resumption of large-scale asset purchases intended to spur growth and lower unemployment stuck near a 26-year high.

“It’s pretty much a crapshoot,” former Fed Governor Lyle Gramley, now senior economic adviser at Potomac Research group in Washington, said of using an inflation target to support prices. “We don’t really have any background of history to know how it’s going to work.” Still, “it’s worth trying.”

Deflation Risk

Bernanke, 56, said in a speech today at the Boston Fed that “inflation is running at rates that are too low” relative to what the Fed considers consistent with its longer-run goals and that “the risk of deflation is higher than desirable.”

He said the central bank could expand asset purchases or change the language in its statement, without giving new details on how the Fed would undertake those strategies or give assurances the Fed’s Open Market Committee will act at its Nov. 2-3 meeting.

The minutes of last month’s meeting signaled concern among officials about too-low inflation: The report said businesses had “little pricing power” to pass on costs of some commodities and imported goods. Also, declining short-term inflation expectations would increase short-term real interest rates, after taking inflation into account, the minutes said.

Bond traders’ inflation expectations for the next five years, measured by the breakeven rate between nominal and inflation-indexed bonds, rose to 1.68 percent yesterday, the highest level since June, from 1.47 percent on Oct. 12, when the minutes were released.

Consumer Confidence

The Thomson Reuters/University of Michigan consumer confidence survey released today showed consumers in October expected an inflation rate of 2.6 percent over the next 12 months, compared with 2.2 percent projected in September.

New York Fed President William Dudley, in an Oct. 1 speech, listed setting a target for higher inflation as one option for stimulating the economy. While the strategy may avert deflation, or an outright decline in prices, it also risks pushing interest rates higher if investors conclude the Fed “was tinkering with its long-run inflation objective,” he said.

Boosting inflation ranks low among incentives for companies to increase investment, said Martin Regalia, chief economist at the U.S. Chamber of Commerce in Washington.

“We’re starting to talk about some true Buck Rogers monetary policy,” Regalia said, referring to the fictional 25th-century space explorer. “We haven’t spent a whole lot of time dealing with these more esoteric approaches to Fed policy.”

Asset Purchases

The Fed in March ended its program of large-scale asset purchases after buying more than $1.7 trillion in Treasuries and mortgage debt. In August, as the economy slowed, it decided to buy Treasuries to replace maturing mortgage debt and keep asset holdings stable at about $2 trillion.

Just two months ago, Bernanke dismissed a proposal by some economists to raise the Fed’s inflation goal.

“Such a strategy is inappropriate for the United States in current circumstances” and could end up “squandering the Fed’s hard-won inflation credibility,” Bernanke said in an Aug. 27 speech in Jackson Hole, Wyoming.

The European Central Bank and Bank of England are among central banks that target an inflation rate through monetary policy. The Fed, by contrast, has no formal inflation objective; instead, Fed officials state a long-run inflation rate they see as consistent with achieving stable prices and maximum employment.

Economic Projections

While Bernanke backed inflation targeting as an academic and a Fed governor, he failed to gain a consensus for one after becoming chairman. Instead, policy makers decided in 2007 to expand their forecasts to include new “long run” projections for growth, inflation and unemployment. Currently, policy makers prefer an inflation rate of about 1.7 percent to 2 percent.

Bernanke may be drawing on work that he and other economists did a decade ago, exploring solutions to deflation in Japan.

Lars Svensson, a former Bernanke colleague at Princeton University who is now deputy governor of Sweden’s central bank, said in a 2000 paper that inflation targeting is part of a “foolproof” plan for escaping a liquidity trap -- if paired with devaluating the currency and pegging the exchange rate. In a liquidity trap, additions to the money supply fail to stimulate the economy.

Bank of Japan

In 2001, the Bank of Japan committed to keeping interest rates low until consumer prices, excluding fresh food, stabilized at or above zero percent. The BOJ raised its key rate from near zero in 2006 as the country emerged from more than seven years of deflation and doubled it to 0.5 percent in 2007.

The BOJ lowered the rate again in 2008 to 0.1 percent, and the country has since relapsed into deflation. On Oct. 5, the central bank pledged to hold its benchmark rate at “virtually zero” until officials foresee a sustained end to deflation.

The Bank of Japan could have been more effective if it had targeted inflation of at least 1 percent, Kazuo Ueda, a policy maker there from 1998 to 2005, said in a paper prepared for the Boston Fed conference, which concludes tomorrow.

In the September minutes, the Fed mentioned two other possible ways to raise inflation expectations: targeting the level of prices, as opposed to the rate of change, and targeting nominal gross domestic product, which isn’t adjusted for inflation. By targeting the price level, the central bank would offset below-goal inflation in one period with faster price increases later on.

Price-Level Target

Price-level targeting has almost no history outside of Sweden, which in the 1930s used it to stop deflation, along with abandoning the gold standard and cutting interest rates, according to a 1998 paper by Claes Berg and Lars Jonung of Sveriges Riksbank, the country’s central bank.

“I am skeptical that it can work as it does in the theoretical models,” said Richard Clarida, a Columbia University professor who’s also a global strategist at Pacific Investment Management Co., which manages the world’s biggest bond fund. One reason is that a Fed chairman or FOMC can’t easily commit their successors to following the same policy, Clarida said at the Boston conference.

Allan Meltzer, a Fed historian and professor at Carnegie Mellon University in Pittsburgh, said a strategy of trying to boost inflation would be “foolish.”

“We’ve known at least since the 1960s that higher inflation will not give us a permanent reduction in unemployment,” said Meltzer. “We’re not going to have high inflation under any circumstances until people start to borrow money.”

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