Whatever Happened to Inflation?

A look back at controversial predictions about monetary policy

Since 2008, the Federal Reserve has been trying to stave off economic disaster with an unconventional monetary policy tool known as quantitative easing. By buying financial assets from commercial banks and other institutions, the Fed has massively expanded the money supply-quadrupling it since the practice began.

Many economists, particularly followers of the Austrian school, deplored the practice and predicted that the unprecedented currency and asset price manipulation would lead to huge and damaging price inflation. reason was among them, declaring on our October 2009 cover: "Inflation Returns!" A group of free market economists were asked: "Has the time come to stockpile canned goods and pick up a wheelbarrow for transporting currency, or should we be afraid of the opposite-a prolonged contraction that causes prices to crash?"

Six years later, official consumer price index inflation sits at just 2 percent annually from July 2013 to July 2014, the latest period for which figures are available. This is identical to the rate for the previous year.

We asked four economists and market analysts to revisit what they originally predicted would happen after quantitative easing and assess whether (and why) they were right. Analyst Peter Schiff sticks to his guns, saying that any "claims of victory over inflation are premature and inaccurate. Inflation is easy to see in our current economy, if you make a genuine attempt to measure it." Economist Robert Murphy believes we are in a "calm before the storm" and is "confident that a day of price inflation reckoning looms." Contributing Editor David R. Henderson writes that the "financial crisis has brought such major changes in central banking that uncontrolled inflation from discretionary monetary policy is not as great a danger as it once was," though he remains critical of the Fed's growing powers. And economist Scott Sumner claims victory for the "market monetarists," noting that both Austrians and Keynesians have been proven wrong by events, and urging both sides to "take markets seriously."—Brian Doherty

Where Is the Inflation?

Peter Schiff

Back in 2009, when the federal government began running trillion-dollar-plus annual deficits and the Federal Reserve started printing trillions of dollars to buy Treasury debt and subprime mortgages, economists debated whether much higher inflation was inevitable. Mainstream economists (who hold sway in government, the corporate world, and academia) argued that as long as the labor market remained slack, inflation would not catch fire. My fellow Austrian economists and I loudly voiced the minority viewpoint that money printing is always inflationary—in fact, that it is the very definition of inflation.

Today, with price inflation still not rampant, it's hard to ignore the victory chants coming from the White House press room, the minutes of the Federal Reserve's Open Markets Committee, the talking heads on financial television, and the editorial pages of The New York Times. They claim that the Fed's extraordinary monetary policy and the government's fiscal stimulus have succeeded in keeping the economy afloat through the Great Recession without sparking inflation in the slightest. Deflation, they argue, is still the bigger threat. Their claims of victory are premature and inaccurate. Inflation is easy to see in our current economy, if you make a genuine attempt to measure it.

The Consumer Price Index (CPI) doesn't qualify as a genuine attempt to measure inflation. The CPI report for July 2014 came in at 2.0 percent year-over-year. But because of consistent alterations in how the data is calculated, the CPI has hidden price increases under a blanket of subjective "adjustments." While the details are intricate, the results can be glaring.

For instance, between 1986 and 2003, the CPI rose by 68 percent (about 4 percent per year). Over that 17-year period, the "Big Mac Index," a data set compiled by The Economist that tracks the cost of the signature McDonald's burger, rose at a nearly identical pace. Since then, this correlation appears to have broken. Between 2003 and 2013, the Big Mac Index rose more than twice as fast as the CPI (61 percent vs. 25 percent). The sandwich, which reflects the average person's direct experience, may be a more accurate yardstick of inflation.

Meanwhile, the Fed is pushing up prices not reflected in the CPI. Through its zero-interest-rate policy and direct asset purchases via quantitative easing, the Fed has lowered the cost of capital and raised prices for stocks, bonds, and real estate. In doing so, it has argued that rising asset prices create a "wealth effect" and are thus a key goal of its monetary policy.

Over the past five years, the prices of these financial assets have risen dramatically. However, unlike past periods of bull asset markets, these increases have not been accompanied by robust economic growth. To the contrary, the last five years have seen the slowest non-recession economic growth since the Great Depression.

This Fed-driven dynamic explains the rich-get-richer economy we've seen since the alleged recovery of 2009 began. The wealth effect has allowed the elites to push up prices for high-end consumer goods such as luxury real estate, fine art, wine, and collectible cars. But that is cold comfort to rank-and-file Americans struggling to find work in an otherwise stagnant economy.

Broader consumer price inflation has been kept at bay because many of the newly printed dollars don't even hit our economy. Instead, foreign countries purchase them in an attempt to keep their own currencies from appreciating against the dollar. In the current environment, a weak currency is widely (and wrongly) seen as essential to economic growth. That's because a weak currency lowers the relative price of a particular country's manufactured goods on overseas markets. Nations hope those lower prices will lead to greater exports and more domestic jobs.

Thus we see "currency wars," in which the victors are those who most successfully debase their currencies. That policy perpetuates greater global imbalances (between those nations that borrow and those nations that lend) and the accumulation of dollar-based assets in the accounts of foreign central banks.

The more debt the U.S. government issues, the more purchases these foreign banks must make to keep their currencies from becoming more valuable relative to ours. It is no coincidence that many of the countries heavily buying U.S. dollars, such as China, the Philippines, and Indonesia, are experiencing high levels of domestic inflation. Inflation may now be America's leading export.

In recent years, U.S. federal deficits have declined from more than $1.2 trillion to less than $600 billion. This is not because the government has made hard choices to raise revenue or cut spending but because rising asset prices have resulted in greater tax receipts from the wealthy. Yet this windfall can only last until the next meaningful correction in asset prices. If tax revenues fall, growing federal deficits would compel the Fed to print the difference. In that case, foreign banks would need to buy even more dollars to maintain their currency valuations. If they lose the will to keep pace, the dollar would lose relative value. A weaker dollar could be the spark that finally ignites significant CPI inflation in the United States.

As foreign currencies gain strength, consumers in those countries will gain buying power and more finished products will gravitate toward foreign shelves. Given that a significant portion of the products we now buy are imported, the diminished domestic supply could push up prices for common products like apparel, electronics, and appliances.

The Fed used to be considered effective when it kept inflation low. Today, inflation is the goal. This is especially true for the Federal Reserve as led by Janet Yellen, who looks set to be the most dovish-on-inflation chairperson in the bank's history. The inflation created by the U.S. government has been delayed, not avoided. Already the costs of everyday goods are rising faster than incomes. This is why economic pessimism is so prevalent on Main Street. Sadly, that gap is likely to get much worse.

Mainstream economists would have us believe that inflation and a weak labor market can't exist simultaneously. Have they ever been to Argentina? Do none of them remember the stagflation of the 1970s?

The truth is that high levels of unemployment are historically correlated with higher inflation and low levels of unemployment with lower inflation. That is because an economy that more fully utilizes labor resources is more productive. More production brings down prices. In contrast, an economy that does not fully employ its citizens is less productive, and its government is more prone to pursue misguided inflationary policies to stimulate the economy.

Although America's policies may not differ dramatically from what has been disastrously tried by Argentina, the dollar is for now protected by the international reserve status that it has enjoyed for almost 70 years. But that privilege has its limits. The dollar may be bigger and more globally integrated than any other paper currency, but in the end, its value may be just as ephemeral.

Peter Schiff is CEO of Euro Pacific Capital and author of The Real Crash: America's Coming Bankruptcy (St. Martin's).

The Calm Before the Storm

Robert Murphy

Since the fall of 2008, I have been among the economists, many from the Austrian tradition, warning the public about the disastrous policies enacted by the Federal Reserve in response to the financial crisis. The Fed was generating unprecedented increases in the monetary base, which is the quantity of dollars held by the public as currency and held as reserves by commercial banks. In late 2009, I made a public wager with economist David R. Henderson in which I predicted a 10 percent year-over-year increase in the Consumer Price Index by January 2013. I lost that bet. In general, warnings about price inflation seem to have been premature at best, totally wrong at worst.

It's true that consumer prices did not zoom up as I had predicted, but my objection to the Fed's post-crisis policies was never dependent on that specific forecast. Indeed, the distinctive feature of Austrian business cycle theory is that "easy money" causes the familiar boom-bust cycle by affecting relative prices. Regardless of the purchasing power of the dollar, the Fed's actions have definitely interfered with interest rates, hindering the communication of information about the condition of the credit markets. By postponing needed readjustments in the structure of production, the Fed's actions have allowed the problems apparent in the fall of 2008 to fester.

I am still confident that a day of price inflation reckoning looms and that the U.S. dollar's days as the world's reserve currency are numbered, though I have no way of gauging the duration of this calm before the storm. Still, my 2009 predictions about consumer price inflation were wrong, and it's useful to analyze why.

At the time, I thought the Fed's policies were simply going to kick the can down the road and exacerbate the underlying structural imbalances in the economy. The housing bubble had itself been fueled by the artificial monetary stimulus and rate cuts under previous Fed chair Alan Greenspan (in response to the dot-com crash and the 9/11 attacks), and Bernanke seemed to be drawing from the same failed playbook. We would simply replace one bubble with another: in this case, swapping a bubble in U.S. Treasuries (and the U.S. stock market) for the collapsing housing market.

That all still seems true. My crucial mistake back in 2009 was in predicting that other investors would come to agree with my assessment in a year or two. In other words, I thought they would look ahead, realize Bernanke had no exit strategy, and then short the dollar (and other dollar-denominated assets) to avoid holding the bag. More specifically, I thought that commercial banks would eventually realize they needed to get their excess reserves in higher-yielding assets.

Once the commercial banks started this process, the quantity of money in the broader sense (captured in aggregates such as M1 and M2, which include the public's checking account balances at the banks) would begin to reflect the enormous spike in the monetary base the Fed had directly engineered. Remember that in our fractional reserve banking system, when the Fed buys $1 billion (say) in assets and thereby adds $1 billion in new reserves to the system, if the commercial banks proceed to make new loans, then in the process they will create (say) an additional $9 billion in new money, broadly measured. In 2009 I thought more and more investors would begin to anticipate this process, anticipating that the money supply held by the public eventually would start to soar, so that large-scale price inflation would become a self-fulfilling prophecy.

But the U.S. economy has stayed in this holding pattern, where people expect low consumer price inflation and so commercial banks keep their excess reserves earning 25 basis points parked at the Fed rather than make new loans. Thus the process I described above has been thwarted; the quantity of money held by the public right now is much lower than it would be, if the banks decided they would rather make loans and earn a higher interest rate than the 25 basis points currently paid by the Fed.

I do not believe the Federal Reserve can gracefully exit from its current position. Fed officials eventually will be in an untenable position in which they must choose to either (a) crash the financial markets by selling off assets and letting interest rates rise sharply or (b) let the dollar fall quickly in value against consumer goods and services. But in the last six years, they have been granted a very generous grace period before having this hard choice foisted upon them.

According to Austrian business cycle theory, as developed by Ludwig von Mises and elaborated by Friedrich Hayek (who would later win the Nobel Prize partly for this work), interest rates serve a specific purpose in a market economy. Intuitively, the more society saves and is willing to defer immediate gratification, the more we want entrepreneurs to invest real resources in longer-term projects. When the central bank injects new money into the credit markets, this not only lowers the purchasing power of money (other things being equal) but artificially suppresses interest rates and renders long-term projects profitable that in reality should not be pursued.

In the Austrian view, therefore, consumer prices are not a reliable gauge of the "looseness" or "tightness" of monetary policy. Irving Fisher infamously thought the Fed in the 1920s had done a good job because the CPI had been tame, whereas Mises knew that a crash was brewing by the late 1920s.

Fearing an imminent spike in consumer prices because of the Fed's unprecedented actions since late 2008 turned out to be wrong-but if wrong in spirit or merely in timing, only time will tell.

Bernanke's policies were harmful regardless of the impact on the CPI. Pumping enormous amounts of money into the credit markets doesn't make us richer. It just distorts the coordinating function of interest rates. Remember, Greenspan did us no favors by pumping up the housing bubble. Whether or not a massive bout of price inflation breaks out, a crash in the real economy should still be expected.

Robert P. Murphy ([e-mail]) is senior economist at the Institute for Energy Research and the author of The Politically Incorrect Guide to Capitalism (Regnery).

High Inflation Still Unlikely

David R. Henderson

Ever since Federal Reserve Chairman Ben Bernanke commenced quantitative easing in October 2008, many commentators have warned about the danger of inflation. There are good reasons to be concerned-including the unprecedented expansion of the monetary base and the Fed's bloated balance sheet-but many Fed watchers are fighting the last war.

The financial crisis has brought such major changes in central banking that uncontrolled inflation from discretionary monetary policy is not as great a danger as it once was. The Fed now has a variety of exotic tools that can prevent any sudden expansion of the broader monetary measures. These tools are partly what have already prevented quantitative easing from causing serious inflation.

Moreover, the Fed monitors banks and other financial institutions so closely that it cannot be caught napping, and implicit inflation targeting has become a dominant Fed goal. The real danger is not runaway inflation. It's that the Fed is becoming more and more intrusive in shaping how national savings are allocated.

The prevalent worry is that once the economy gets back to normal and interest rates start to rise, banks will increase their loans. And when that happens, many fear, the Fed has no viable exit strategy to hold back inflation.

Central banks traditionally dampen inflation by reducing the monetary base via selling off assets or, equivalently, calling in and not rolling over loans. Those who predict future uncontrolled inflation believe this cannot be accomplished quickly enough without major disruption of credit markets. Aggravating this problem is that the Fed's balance sheet now contains large quantities of mortgage-backed securities and long-term Treasury debt, not just the short-term Treasury securities that were its primary asset in the past. The Fed can quickly reduce its balance sheet by not buying new short-term Treasuries when the old ones mature. With long-term Treasuries, by contrast, the Fed must sell many of them on secondary markets. This could drive prices down, disrupting credit markets and causing losses for the Fed on its portfolio.

But the Fed no longer has to rely on dumping assets to impose monetary restraint. It can use four other methods to accomplish the same goal. These comprise either completely new tools or older tools that were previously of minor importance.

They are:

1. Loans to the Fed from the U.S. Treasury.

2. Reverse repurchase agreements (reverse repos)-that is, borrowing by the Fed. The Fed sells a security from its portfolio with an agreement to buy it back. Under new Fed chairman Janet Yellen, the Fed uses this device extensively, borrowing over $200 billion.

3. Term Deposit Facility, a mechanism through which banks can convert their reserves deposited at the Fed (which are just like Fed-provided, interest-earning checking accounts for banks) into deposits of fixed maturity at higher interest rates set by auction (making them just like Fed-provided certificates of deposit for banks). Fed officials have made clear their intention to employ the Term Deposit Facility liberally if necessary. This would drain bank reserves by converting bank deposits at the Fed from implicit loans to explicit, higher-interest-earning loans with fixed maturities.

4. Interest on reserves. The most important way the Fed began borrowing and continues to do so is by paying interest to banks on their reserves. Permission to do so was included in the Troubled Asset Relief Program (TARP) Act, and the Fed started using that power within days. Interest-earning reserves have encouraged banks to raise their reserve ratios rather than expand loans to the private sector. This tool thus constitutes a flexible substitute for reserve requirements.

The rate that the Fed pays on reserves started out as high as 1.4 percent on required reserves and 1 percent on excess reserves, but it is now fairly low on both: 0.25 percent. Yet the alternatives available to the banks are little better, especially after adjusting for risk. It is the gap between these rates that determines the incentive for individual banks to hold reserves. The interest on three-month Treasury bills remains lower, and both T-bills and reserves are assets that impose no legally mandated capital requirements on banks.

By paying interest on reserves, the Fed has made itself the preferred destination for much bank lending. Should market interest rates begin to increase, raising the prospect of increased bank lending and inflation, the Fed can increase the interest rate it pays, locking up bank reserves and keeping reserve ratios high.

These four tools combined make it possible for the Fed to prevent any expansion of the broader monetary measures without selling off any assets. Of course, the Fed may supplement these tools with some asset sales, but sales are unlikely to be large initially. Interest on reserves will almost certainly be the dominant exit tool.

Treasury deposits may not become significant again, given the national government's huge deficits. Use of reverse repos could be somewhat constrained by Fed concerns about the solvency of the counterparties it borrows from, whereas this is not a serious consideration for highly regulated and monitored commercial banks. Term deposits are just a modified way of paying interest to banks.

Another issue that could affect the exact mix is how these tools affect Fed income. Treasury deposits are the only exit tool that cannot reduce Fed earnings. The Fed pays no interest on Treasury deposits directly, so the Treasury would bear the cost of rising market interest rates if it engaged in extra borrowing on behalf of the Fed. This would be offset only partly by the Fed's regular remittances of its excess earnings to the Treasury. On the other hand, paying higher interest on reserves, on reverse repos, and on term deposits would all directly curtail Fed earnings, whereas any large sale of assets could impose capital losses.

Rep. John Campbell, a California Republican who heads the monetary policy and trade subcommittee of the House Financial Services Committee, has warned that central bank losses are "a legitimate concern and something we will be watching." It would be truly ironic if congressional and popular hostility to the Fed pressured the Fed to create more money to keep Treasury remittances flowing, possibly contributing to the very inflation that so many Fed critics fear. And if the Fed's exit strategy coincides with a Treasury fiscal crisis, all bets are off. That last scenario, though, would arise, not from Fed monetary policy per se, but from Congress' and the president's deficits and debt.

My analysis is not advocacy. I do not claim that it is good for the Fed to have these powers. Indeed, as I argued in a presentation at the San Francisco Federal Reserve Bank in April, I would like the Fed to have zero power. The Federal Reserve's sorry century-long record is evidence for its failure. But the issue at hand is whether the Fed's actions will produce high inflation. That is highly unlikely.

Contributing Editor David R. Henderson is an associate professor of economics at the Naval Postgraduate School in Monterey, California, and a research fellow with Stanford University's Hoover Institution. He blogs at econlog.econlib.org.

Neither Hyperinflation Nor a Liquidity Trap

Scott Sumner

The Fed has responded to the Great Recession with a variety of unconventional monetary policies. These policies have been interpreted, or perhaps I should say misinterpreted, in two notable ways.

On the right, many economists and pundits have expressed concern that low interest rates and lots of monetary expansion would lead to high inflation. On the left, Keynesian economists argued that monetary policy is ineffective once interest rates have fallen close to zero. This led them to advocate fiscal stimulus.

Events of the last six years have decisively refuted both of these widely held views. Instead, a relatively small and little-known group-the market monetarists-has offered the most persuasive account of recent policy. Monetary policy continues to be highly effective at near-zero interest rates, but in most cases actual monetary stimulus has been far too weak to promote high inflation, or even an adequate recovery.

I am one of the market monetarists. Here are our arguments:

1. The decline in interest rates to near-zero levels did not represent easy money, but rather the effects of a weak economy. When nominal GDP growth is very slow, as in the early 1930s or in Japan in the 1990s, nominal interest rates tend to fall toward zero. That does not mean "easy money," nor does it mean high inflation is on the way. In contrast, very high interest rates usually occur during periods of very high inflation, when monetary policy is very expansionary.

2. Once interest rates have fallen close to zero, there's no opportunity cost in holding the kind of money produced by the Federal Reserve: currency in people's wallets and bank reserves (which are essentially cash held by commercial banks, often as electronic deposits at the Fed). In previous low-interest-rate environments, such as the 1930s in America and more recently in Japan, central banks were able to "print" lots of money without generating high inflation rates.

In addition, beginning in 2008 the Fed started to pay a small amount of interest on bank reserves, which made banks even more willing to hold onto that cash. Recall that traditional economic theory says that printing money is inflationary because it's a sort of hot potato. The kind of money produced by the Fed prior to 2008 did not earn any interest. Thus, when interest rates are positive, people and banks don't want to hold onto lots of currency and bank reserves. As they try to get rid of these excess cash balances, they purchase goods, services, and assets, driving up prices in the long run. That's why printing money is usually inflationary. But when interest rates are close to zero, the hot potato effect is much weaker, and central banks can print large quantities of money without creating substantial inflation.

If printing money is not inflationary at zero interest rates, what's wrong with the Keynesian argument that we need to rely on fiscal policy because monetary policy is stuck in a "liquidity trap"?

Many Keynesians ignore the role of expectations. Although the U.S. is currently experiencing near-zero interest rates, that won't go on forever. At some point in the future, interest rates will be positive and monetary injections will have an inflationary effect. More importantly, the expectation of higher inflation in the future is expansionary right now. These expectations lead to higher asset prices (stocks, bonds, real estate, commodities, and foreign exchange), which boosts aggregate demand and inflation.

If the Keynesian argument were true, it would be possible for a single central bank to buy up all of the world's assets with newly printed money without creating inflation. Does that sound too good to be true? Do you really believe that a fiat-money central bank would be unable to debase its currency if it wanted to? Do you believe the Fed doesn't know how to create the sort of hyperinflation experienced in Germany in the 1920s and in Zimbabwe more recently?

Contrary to what you may have read in the press, the Fed has never said it was "out of ammunition"; indeed exactly the opposite. When they've made moves like "tapering"-slowing the pace of money printing-it's because they didn't think the economy needed more stimulus, not because they were running out of paper and green ink.

The Keynesians have made a number of predictions in recent years based on the assumption that monetary policy is ineffective when the economy is in a liquidity trap. Perhaps the most famous Keynesian pundit is Paul Krugman, who expressed skepticism about whether the Swiss central bank and the Bank of Japan would be able to depreciate their currencies when interest rates were stuck at zero.

Soon after he expressed those doubts, both central banks undertook bold policies that successfully held down the value of their currency in the foreign exchange market. The Bank of Japan's decision to adopt a 2 percent inflation target had an electrifying impact on asset markets in Japan and led to an acceleration in both inflation and real GDP growth in 2013.

Keynesians like Krugman also predicted that fiscal austerity would slow economic growth. And yet, though the U.S. has been more austere than the eurozone, since 2011 economic growth has been much higher in the U.S. than the eurozone. The reason for the difference is clear: The European Central Bank had a more contractionary monetary policy, leading to below-target inflation, while the U.S. engaged in unconventional stimulus efforts such as quantitative easing and "forward guidance" (trying to shape market expectations through announcements of its near-future intentions), generating slightly higher inflation.

In early 2013, Krugman said the year would be a "test" of market monetarism, specifically the assumption that fiscal policy is ineffective because it is offset by monetary policy. Most Keynesians expected 2013 to see a sharp slowdown, due to fiscal austerity such as higher income taxes, a 2 percent higher payroll tax, and lower government spending associated with the April 2013 sequester.

In late 2012, the Fed pursued a third round of quantitative easing and aggressive forward guidance with the goal of offsetting the expected fiscal austerity. The results of this experiment could not be clearer. Contrary to the Keynesian prediction, GDP growth did not slow. Indeed, real GDP growth from the fourth quarter of 2012 to the fourth quarter of 2013 was nearly double the pace of the previous four quarters.

We've seen plenty of experiments in Switzerland, Japan, Britain, and the U.S., which clearly demonstrate that monetary policy can be effective at near-zero interest rates. This should have been no surprise, as even Franklin Roosevelt was able to stimulate the economy in 1933 by devaluing the dollar when interest rates were close to zero.

Market monetarists succeeded in our pre­dictions because we take markets seriously. Conservatives who predicted higher inflation should have seen the low inflation forecasts in the financial markets as a warning sign that their models were flawed. Liberals who thought that monetary policy couldn't work at near-zero interest rates should have paid more attention to the fact that financial markets often rallied strongly on signals of monetary stimulus and fell sharply on signs that the stimulus would be cut back.

Market signals aren't perfect, but they're much better than the predictions of academic economists or government bureaucrats.

Scott Sumner ([e-mail]) is a professor of economics at Bentley University.