Why the Fed Isn't Igniting Inflation

Ever since the late economist Milton Friedman wrote in 1963 that "inflation is always and everywhere a monetary phenomenon," central bankers have been on notice that printing too much of the green stuff jeopardizes their legacies as guardians of sound money. Yet Federal Reserve Chairman Ben Bernanke is unleashing a tidal wave of money to fight the global recession. The nation's monetary base—consisting of bills and coins in circulation plus banks' deposits at the Fed—has climbed 114% over the past year through May. For comparison, the biggest annual increase before this crisis, going back as far as 1960, was a little under 16%. It's only natural to wonder whether the Fed is making a big policy mistake that will lead to high inflation, either soon or a couple of years from now.

Crazy as it sounds, though, the Fed is probably going in exactly the right direction. In fact, if anything, the wave of money it's generating may not be big enough. How can that be? Because the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. Whether it's voluntary frugality or under the coercion of creditors, Americans have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years.

The people who worry about inflation—and there are many—may not have fully grasped the multitrillion-dollar ramifications of American households' extended deleveraging. While cleaning up debt is a good thing for the long-term health of the U.S. economy, it's hell on consumer spending, which accounts for about two-thirds of gross domestic product.

The dramatic pullback in consumer spending means money that otherwise would have gone into raising prices is going into propping up the faltering economy. Banks have drastically increased their reserves at the Fed rather than making new loans. That's the biggest cause for the increase in the monetary base. "At every level of the economy and every level of society, the demand for cash is unprecedented," says David A. Rosenberg, chief economist and strategist for Gluskin Sheff & Associates, a Toronto money manager. Says Rosenberg: "If the Fed didn't meet that demand for cash, we'd have a destabilizing deflation on our hands."

As a matter of fact, the economy is teetering on the edge of deflation—a general extended decline in prices—despite the Fed's intervention. Excluding food and energy, consumer prices rose a modest 1.8% in the 12 months through May—and including food and energy, they fell 1.3%, the most since 1950. Cutbacks by consumers are bringing about deflation in business, with unemployment in May at 9.4% and manufacturers using only 65% of their capacity, the lowest since recordkeeping began in 1948. Small businesses that were aggressively raising prices a year ago are now "worried about weak demand, the fact that they don't have many customers," says William C. Dunkelberg, chief economist of the National Federation of Independent Business.


Inflation remains a distant prospect because the retrenchment of the American consumer, which is deflationary, still has a long way to run. Consider that household debt soared from two-thirds of GDP in the early 1990s to three-quarters in 2001 to an even 100% at the end of 2008. Getting back to a more sustainable debt ratio will take years of belt-tightening. Based on today's GDP, simply returning to the 2001 level would require paying off 25% of all outstanding household debt—$3.5 trillion worth.

Even among people who can afford to keep shopping, there's a new ethic of frugality. Down with bridezillas, up with home canning of garden tomatoes. "People are doing their own oil changes again. Women are coloring their own hair," says University of Tampa marketing professor Ronald J. Kuntze. Unfortunately, for the society as a whole, paying off debt is more easily said than done. When shoppers stay home, people lose their jobs. Then they have to cut back even more to make ends meet, creating a deflationary spiral.

True, plenty of legit economists don't buy this low-inflation scenario. Sooner or later, they argue, all that money is bound to show up in prices. "We will soon see a resurgence of inflation and an increase in mortgage rates," says Stanford University economist John B. Taylor, "unless the Fed presents a clear and credible exit strategy from the unprecedented explosion of its balance sheet." For starters, Taylor says the Fed should start to wind down its purchases of Treasury bonds right away. Taylor is famous among economists as the inventor of the "Taylor rule," which describes how the Fed would or should adjust interest rates based on inflation and economic growth. He argues that the negative effects of the Fed's easy money may already be apparent in "increasing oil prices and mortgage rates, which will be a drag on the recovery."

Perhaps. But it's not clear that the evidence Taylor cites—higher oil prices and rising mortgage rates—actually indicates resurgent inflation in the U.S. It's not primarily inflation fear that's pushing up interest rates, but rather massive federal deficit spending. Investors are demanding higher yields to take even more Treasury bonds. In fact, the bond market is forecasting inflation averaging only about 1.8% a year over the next decade, judging from the spread between ordinary and inflation-indexed Treasury bonds. As for high oil prices, they probably do reflect speculation about strengthening economic growth—but perhaps not growth in the U.S. Costly oil could worsen the recession in the U.S. by sucking up money that now goes for other things.

Whether inflation could become an issue in two or three years is irrelevant anyway, argues Gluskin Sheff's Rosenberg. The important thing, he says, is to stave off deflation right now: "Once you get onto the slippery slope of a deleveraging, it's extremely difficult to climb your way out."

In the past, countries where consumers retrenched, such as Japan, were able to fight their way out of recession through exports. The catch this time is that lots of countries from the U.S. to Germany to China are pegging their hopes on export-led recoveries. It's mathematically impossible for all countries to improve their trade balances at the same time—"unless we can find another planet to export to," as Princeton University economist Paul R. Krugman joked at a recent lecture at the London School of Economics.

Economists get paid to worry. But a revival of inflation soon shouldn't be at the top of their worry list.with Ben Levisohn

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