The Economist: Inflation revisited

I wrote briefly about inflation several months ago in my column on the end of quantitative easing. But now that the Federal Reserve is moving closer to reducing its purchases of government securities, let’s take a closer look at the inflation question.

Remember that the Fed tries to accomplish two things: sustainable job growth and stable inflation. It does this through buying and selling treasury securities, which has an immediate impact on bank reserves and interest rates. Most of the focus over the last few years has been on interest rates, which have stayed at record lows for an extended period of time, as the Fed increased its holdings of treasury and agency securities to $3.5 trillion. Prior to the Great Recession and accompanying financial crisis, that figure was below $1 trillion.

Inflation has been well-behaved recently. The Consumer Price Index (CPI), the inflation measure most people look at, was 1.6 percent for the nation in the first eight months of 2013, down from 2.1 percent in 2012. (It was 2.8 percent in metro Denver in the first half of this year, up from 1.9 percent last year.)

The media sometimes focuses on “core inflation,” the increase in the CPI excluding food and energy, implying that this is what guides Federal policy. I often quip that it is a useful measure for anyone who doesn’t eat, drive, heat or cool a home. But there is a reason to strip out these two sectors: Prices can fluctuate wildly with no particular trend, and monetary policy needs to focus on trend inflation, not short-term blips.

Since 2000, the Fed has actually focused on something called the PCE deflator, an inflation measure from the gross domestic product accounts. PCE stands for personal consumption expenditures, the amount of money individuals spend on goods and services. This doesn’t mean the Fed ignores things like core inflation or the consumer price index, but those statistics are secondary concerns.

The PCE deflator is better than the CPI because it accounts for the price of goods and services changing as people’s spending habits change. For example, if the price of beef rises relative to chicken, people tend to eat less beef and more chicken. In other words, unlike the CPI, which tracks a fixed basket of goods and services, the PCE deflator tracks a variable basket.

The PCE deflator was up only 1.1 percent in the first two quarters of 2013. But the potential for much higher inflation as the economy recovers lurks. Still, I don’t expect it to be an issue over the next 12 months.

As the economic comeback — both in the U.S. and among our trading partners — gains strength, consumers will buy more, causing businesses to ramp up production. At first the excess capacity of both equipment and workers will be put to work to handle increased demand, but after a period of time new factories, technology and workers will be needed. Businesses will need to borrow to finance expansion and banks will, at that point, be more willing to make those loans.
In fact, the banks have most of that $3.5 trillion from the Fed’s securities purchases to loan. And loan again and yet again. The details of how the money multiplier works are a topic for another column but trust me, that $3.5 trillion can support many additional trillions in loans.

The problem will arise when the quantity demanded of commodities and computers and properly trained workers, etc. surpasses available supply. Prices will start to increase as the market rations scarce resources to the highest bidder. If nothing is done to stop the cycle, inflation will be off and running.

I am optimistic this won’t occur, not because the economy never returns to operating on all cylinders, but because the Fed has the tools, knowledge and willpower to prevent it. As I’ve mentioned before, the Fed now can pay interest on the deposits banks hold with it, a tool that wasn’t available in previous inflation cycles. In theory at least, the Fed can set the rate high enough that banks will keep their money rather than make risky loans.

There’s no question that prices will rise over the next several years, as will interest rates. But with a little luck and strong leadership from the new Fed chair, I believe we will avoid inflation levels that damage the economy.