The Biggest Economic Mystery of 2013: What's Up With Inflation?

Despite QE3, core inflation just hit a 50-year low


The Fed is "printing" $85 billion a month, but inflation is falling. In fact, core inflation -- that is, excluding food and energy prices -- just hit a 50-year low. What in the name of Rudolf Havenstein is going on?

Inflation is always and everywhere a monetary phenomenon. That's how Milton Friedman famously put it, and, translated from econospeak, it means that prices go up when the amount of money goes up. Simple enough. However, there's a once-in-a-generation caveat to this, and we're living through it now. When short-term interest rates are at zero, printing money won't create inflation if central banks play by the same old rules. And even if they don't, it's hard for strait-laced central bankers to play by new enough rules to push prices up much.

It's a problem of too much credibility. Now, in normal times, credibility is a central banker's best friend. As former Fed Vice Chairman and current Princeton professor Alan Blinder explains, it's easier and less costly for a central bank to bring inflation down -- and keep it there -- if markets believe it will do so. In other words, the Fed won't have to raise interest rates as much to keep inflation on target if people expect the Fed to keep inflation on target.

But this benefit becomes a burden in a liquidity trap. When zero interest rates aren't enough to get the economy moving again, it takes, surprise, negative rates. And that means increasing expected inflation. After all, nominal rates can't go negative -- people would turn deposits into cash if they were losing money on their bank accounts -- but inflation-adjusted rates can. The problem, as Paul Krugman memorably put it back in 1998, is a central bank has to "credibly promise to be irresponsible" to increase expected inflation. In other words, a central bank has to say it will let inflation go above target in the future -- and markets have to believe it won't change its mind in the future. That's not an easy sell for a central bank with decades of inflation-fighting credibility built up.

How Do You Get Central Bankers to Loosen Up?
Economists have tried to figure out how to be irresponsible ever since the 1990s when Japan got stuck in its zero-interest rate, zero-growth trap. The easiest way to seem irresponsible is to change the central bank's target. Such a "regime change" could be something like Larry Ball's call for replacing our 2 percent inflation target with a 4 percent one, or Scott Sumner's plan for a level nominal GDP target. In either case, liquidity traps -- aka, depressions -- should be less likely and less costly. But, of course, the only thing the Fed likes less than promising temporarily higher inflation in the future is promising permanently higher inflation in the future. In other words, the ancien régime isn't close to the chopping block yet.

Instead, the Fed has tried to signal that it will keep interest rates low for quite awhile. These signals have taken two forms: explicit promises to do so, and bond-buying. The former is what economists call "forward guidance" and the latter is "quantitative easing". Okay, but how exactly are these supposed to work? Promises are simple enough -- the Fed says it won't raise rates before unemployment falls below 6.5 percent or inflation rises above 2.5 percent -- but quantitative easing is trickier. People, including sometimes Ben Bernanke, call it "printing money", but that isn't quite right. The Fed does create money -- yes, out of "thin air" -- to buy bonds from banks, but that money has ended up as bank reserves that currently pay interest. There's no reason that should be inflationary as long as risk-averse banks keep sitting on these reserves. And there's little reason the banks won't keep doing so if the Fed increases the interest it pays on reserves in the future. So what's the point? Well, as Gauti Eggertsson and Michael Woodford argue, quantitative easing can show the Fed is committed to keeping rates low for long. Buying long-term Treasury and mortgage bonds from the private sector aligns the Fed's interests with the private sector's interests: both would take losses on their bonds if rates rise. The Fed, which jealously guards its independence, presumably would want to delay the day when it might need the Treasury to recapitalize it -- meaning it would keep rates low. That should push inflation up, and it did.

Until now.

The Incredible Shrinking Inflation Rate
The Fed looked like it got it right this time. Or at least more right. Its first two rounds of bond-buying did increase inflation back when it looked like prices might start falling -- but not for long. Part of the problem was the Fed was only buying a specific dollar amount of bonds; not buying bonds until it got the result it wanted. But the Fed fixed this flaw with QE3. It said it would buy $85 billion of bonds a month until the labor market improved "substantially". As James Bullard, the president of the St. Louis Fed, pointed out in a talk I moderated, job growth has indeed increased since QE3 began, but inflation has not. It's fallen. Now, as I pointed out before, the Fed didn't actually try to push up inflation expectations with QE3, but it did try to anchor them even more firmly at 2 percent. Inflation shouldn't be going down now. But, as you can see in the chart below of core PCE inflation, the Fed's preferred measure, that's exactly what's happened since last September.

It's not clear what is going on here. But, as Bullard argues, it's probably not a story about commodities. If it was just about low demand in the rest of the world translating into low inflation here because of lower oil and food prices, we wouldn't see core prices falling quite as much. But they are. Indeed, as I mentioned before, core inflation is at its lowest level since 1963. It's lower now than the worrying low level it hit in 2010 that scared the Fed into launching QE2 to avert deflation.

Okay, but what are the possible culprits in this disinflationary whodunit? Well, it might be that markets have noticed the man behind the quantitative easing curtain, or it might be that austerity is winning the tug-of-war over prices with the Fed. Let's consider these in turn.

-- Is this just a Jedi mind trick? The Fed has gone out of its way to let everyone know that quantitative easing will not -- repeat, will not! -- be inflationary. For one, Ben Bernanke has explained that the Fed can and will raise interest on reserves to prevent banks from flooding the economy with an inflationary surge of new loans; for another, the Fed has explained that it probably won't lose much money on the bonds on it owns, and that even if it does, that wouldn't stop it from raising short-term interest rates. In other words, the Fed has done its best to sure quantitative easing doesn't work by making sure markets know t's not promising to be irresponsible. Still, I'm not sure how much markets have noticed. Indeed, stocks swoon every time the Fed hints that it might "taper" its bond buying -- not what you would expect if people thought quantitative easing was just a confidence game.

-- Is it the austerity, stupid? That giant sucking sound you hear is the government taking demand out of the economy. As you can see on the left axis above, total government spending -- that is, federal plus state and local -- as a percent of potential GDP has been on a steady downward trend since 2010. It's a three-act story of bad policy. First, the stimulus peaked, and then reversed prematurely; then, state and local governments began slashing budgets to balance them as they are required; and now, the federal government is cutting spending in the dumbest way Congress could come up with -- the sequester. Now, QE2 did manage to increase inflation despite some austerity, but there's more of it this time around. The chart above only shows total spending through January 2013; it doesn't include the sequester, or, for that matter, the tax side of austerity. Between the spending cuts and the expiring payroll tax cut, the fiscal contraction the past six months has probably overwhelmed any "money-printing".

But the mystery of our falling inflation rate should make one thing less mysterious: when the Fed will start tapering its bond-buying. The answer is not anytime soon. Yes, 5-year breakevens show that expected inflation is still close to target, but as long as actual inflation is so low, the Fed will not ease off the accelerator. That was Bullard's recent message, and he told me he'd like to see inflation get around its 2 percent target before he'd be comfortable reducing the Fed's monthly bond purchases.

Now the Fed just has to figure out how to increase inflation in an age of (bigger) austerity.