The Sweet Smell of Inflation, or, Never Trust Anybody Who Says "Nascent"


Dream sweetly, Americans, in your cardboard tents. With a sure hand on the tiller, Ben Bernanke is steering us through the night. Today, the chairman of the Federal Reserve Bank sent forth a dove to find the shore inflation, and the dove returned, and Bernanke saw that it was good, and verily he raised the Fed's discount rate from 0.5 percent to 0.75 percent.

This is the discount rate, which the Fed charges to banks that borrow money from its reserve balances. The more closely watched Fed funds rate, which banks charge each other to borrow from the Fed's reserves, is unchanged at 0 to 1/4 percent.

If you're a Fed believer, you may say this is an example of the kind of "careful policy choices" Federal Reserve Bank of Minneapolis President Narayana R. Kocherlakota promised in a popular speech this week. Addressing the Minnesota Bankers Association, Kocherlakota stopped just short of calling the nascent recovery inchoate: 

[E]ven very bad recessions do come to an end. There is a nascent recovery under way. As I will describe, I expect it to continue. However, my own forecast is that the recovery in GDP and especially unemployment will be slow because of uncertainties relating to various legislative initiatives and problems in the banking sector. I do think the news is mostly good on the inflation front, although the need for careful policy choices is even more critical than usual.

Why do I say that a recovery is under way? Real GDP began to grow again in the third quarter of 2009. In fact, that growth rate accelerated to a seasonally adjusted annualized rate of 5.7 percent in the fourth quarter. My own prediction is that the National Bureau of Economic Research will declare this recession to have ended sometime in the second half of last year. However, GDP is not the whole story. It is true that, as measured by unemployment, the economy is still stuck in a trough. I will have more to say about that in a few minutes.

Kocherlakota has an interesting discussion of the vast number of newly created dollars banks are holding in reserve. But he doesn't mention that one of the reasons banks are holding so much cash is that the Fed is paying them interest on it. This experiment in monetary policy is being conducted under the Financial Services Regulatory Relief Act of 2006, which authorized the Fed "to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011." The Emergency Economic Stabilization Act of 2008 (now more commonly known as the "bailout" or "TARP") made the start date retroactive to October 1, 2008. This allows the Fed to create trillions of new dollars without having the effects be immediately detectable in the nation's wheelbarrows.

But how long can it go on? Kocherlakota says the outlook for inflation is "basically promising," but then explains how unlikely it is that the return to fractional-reserve lending will happen in an orderly manner:

Deposit institutions are holding over a trillion dollars of excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households' inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve's debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

I hasten to say—and I want to stress—that I view this scenario as unlikely.

Of course you do, Narayana, of course you do.

This Nasdaq summary of the Fed's moves today is a must read, and includes a reminder that the recovery is only latently nascent:

[T]he more modest 0.3 percent rise in PPI excluding food and energy prices indicate that inflationary pressures stemmed primarily from higher gasoline and energy costs. Evidence of lower prices on women's apparel, passenger cars and computers indicates that weak consumer demand is still holding back price growth in other parts of the economy.

Bernanke's major academic work is on the Great Depression, so his attitude toward inflation stems from a core belief that those nations which inflated first were the first to recover. He spent most of the seventies and early eighties playing bass in Olivia Newton-John's touring band, and his studies of the Ford-Carter-Reagan era were less thorough as a result. (And his thesis on the G.W. Bush era is totally insane.) So I'd just like to remind him: Stagflation exists, and it is American.

Speaking of which, does anybody remember certificates of deposit? I mean, they still exist, but does anybody remember when they were the only decent place to put your money?