Monetary Muddle
If the Fed errs on the side of ease, significantly higher inflation will be inevitable.


Brighter economic fortunes are usually met with expectations of less-easy monetary policy from the Federal Reserve. When recession sets in, the Fed loosens its stance to spur recovery. When recovery takes hold, the Fed tightens policy to stave off higher inflation.

But things are going to be different this time around. The Fed got very easy during the financial crisis, going to extraordinary lengths to guard against an outright deflationary implosion. It cut its target rate to near zero and flooded the markets with liquidity. And it is nowhere near ready to declare victory.

Even with the economy turning toward recovery — as indicated by improved manufacturing activity and a decrease in jobless claims — Fed officials continue to rationalize their ultra-accommodative stance as necessary to guard against inflation moving too low.

Indeed, a policy reversal at this point would be premature. Money demand is still elevated today, with cash more favorable than riskier assets. But as markets continue to stabilize and confidence is restored, that extra increment of money demand will fade, and with it the major offset to the Fed’s copious liquidity injections.

At that point, if the Fed is not convinced that conditions have improved enough to justify a normalization of policy, excess liquidity will become entrenched in the system, bringing about a rising-inflation environment.

Chances are, the Fed will err on the side of ease.

For one, it may well be that our central bankers consider a somewhat higher inflation rate to be an acceptable price to pay for shepherding the economy through the danger zone of deflation. Here, higher inflation is the lesser of two evils.

But the current Bernanke administration — as well as the previous Greenspan regime in which Bernanke served — is also driven by the “output gap” model, which holds that as long as economic growth is below potential, the slack in the system will keep inflation under wraps. This is a fallacious concept, as illustrated by several Fed errors in recent years: In the late 1990s, the Fed tightened to restrain strong “above potential” growth in the mistaken belief that it was inflationary, giving us the 2001 recession. Coming out of that recession, the Fed remained too easy for too long in the mistaken belief that sluggish growth was deflationary, giving us a rising-inflation environment.

Based on this past performance, it appears as though the Fed will be content to wait for a run of above-trend growth — gains of 3.5 to 4 percent in real GDP — before initiating any change of course. And that wait could be a long one as caution among economic actors holds back the pace of growth — at least in the first several quarters of the recovery.

The reappointment of Ben Bernanke as Fed chair also tilts the ledger toward policy remaining hyper-easy longer than it would have if an outsider had been nominated to the post. Conventional wisdom has it that candidates like White House economist Larry Summers would have been even more inclined to sustain an easy posture to suit the political needs (i.e., the economic-growth needs) of the Obama administration. But as a novice central-bank chair, Summers would have faced considerable pressure to establish his anti-inflation bona fides, and might well have begun unwinding the Fed’s super-accommodative posture more quickly.

To be sure, since Bernanke’s reappointment in late August, tightening expectations as reflected in the fed-funds futures market have moved to new lows — even as news on the macro economy continues to point toward recovery.

The Fed also will be reluctant to begin tightening while the financial system remains vulnerable. Commercial real estate is still in dreadful shape, with commercial-mortgage defaults mounting, values falling, and the credit needed to refinance maturing loans in scarce supply. The Fed has initiated a program to encourage the issuance of commercial-mortgage-backed securities, but this is just getting underway. As long as the commercial-mortgage market remains in distress, the Fed is unlikely to unwind.

It also can be safely assumed that the Fed is acutely sensitive to the pressures that continue to roil the banking system. While the largest “systemically critical” institutions responded to Fed and Treasury ministrations and emerged whole from the crisis last fall, smaller regional banks are taking it on the chin. The Federal Deposit Insurance Corporation has shuttered more than 80 banks this year, and has assembled a “problem list” of more than 400 institutions that are at risk of insolvency. The Fed will be extremely reluctant to begin tightening with banks showing such signs of frailty.

All in all, it’s difficult to avoid the conclusion that the Fed is charting a course that will leave it in an extraordinarily easy posture, beyond the point when significantly higher inflation becomes inevitable.

David Gitlitz is chief economist of Trend Macrolytics LLC.