Politics & Policy

Ready for Life after Deflation?

Today's ultra-easy Fed policy may mean inflation troubles down the road.

In the face of mounting concern that the economy could slide into a deflationary spiral, the price of gold has rallied as much as $130 off its recent lows. Meanwhile, the dollar’s forex value has sunk precipitously — off more than 10 percent against the euro. Since monetary deflation is experienced as a sustained appreciation of the purchasing power of the unit of account, indicators showing such a sharp erosion of purchasing power would seem to render deflation worries far-fetched.

Not that real deflationary impulses can be ignored. Following the Fed’s December announcement that it will maintain an extraordinary expansion of its balance sheet and will continue flooding the market with dollar liquidity, gold shot higher by some $30 while the dollar fell from $1.37 to $1.44 versus the euro. But in a fresh round of intense risk aversion — as seen, for example, in 3-month Treasury bills yielding close to zero — these fluctuations were all but reversed over the next few days. Absent the Fed’s exceedingly generous liquidity stance, such deflationary tendencies could lead to a damaging outcome not unlike the one Japan experienced in the 1990s.

It’s probably a safe bet, though, that ultra-easy Fed policy will ultimately prevail, and that further sustained declines in the dollar’s real value will occur.

Federal Reserve chairman Ben Benanke built his academic reputation on an understanding of the Fed’s deflationary errors in the early stages of the Great Depression. So it’s no stretch to think he will spare nothing in trying to prevent a repeat performance. Indeed, based on Bernanke’s apparent ordering of priorities, precluding deflation probably ranks well ahead of avoiding inflation.

It’s also worth noting that inflation is a phenomenon central bankers know how to deal with, while deflation terrifies them. If the price to be paid for preventing deflation today is a bout of somewhat higher inflation, Bernanke is more than willing to pay it.

Bernanke also may have gotten some political cover for this position from Greg Mankiw, a Harvard economics professor and former chairman of President Bush’s Council of Economic Advisers. On his influential blog, Mankiw advises that the Fed’s next announcement should include the following declaration:

The committee recognizes that moderate inflation would be desirable under present circumstances. In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today. The committee anticipates keeping the stance of monetary policy sufficiently accommodative to achieve that degree of inflation over the coming decade.

That may be fine as far as it goes: A steady 3 percent annual inflation rate would not present great difficulty for the economy. In fact, it wasn’t all that long ago when getting inflation down to 3 percent was considered a great accomplishment.

A problem arises, however, in the idea that policymakers are somehow capable of calibrating their policy actions to a desired inflation outcome. In truth, the tools of monetary policy are incapable of that kind of precision — a fact exposed in the Fed’s many errors over the years.

In this market and economic environment, the Fed’s current policy stance might be consistent with a 0 percent inflation rate. But once the market stabilizes and the demand for money normalizes, there’s no way of knowing whether the same policy stance would be consistent with 3, 5, or 8 percent inflation.

One way or another, it seems very likely that the present deflation anxiety will in time yield to a new inflation reality. As it is, the softening of the dollar’s value over recent weeks indicates that the Fed was already well on its way to satisfying the market’s demand for money. And with the Fed’s announced recommitment to pumping enormous sums of dollar liquidity into the financial system, it seems inevitable that the Fed will at some point supply liquidity in excess of the market’s demands, thus fostering a return to a rising-inflation environment.

How quickly that happens, and to what extent, will depend on the course of events as the Fed works to relieve the crisis atmosphere still affecting the financial markets. But the following conclusion seems unavoidable: The Fed’s priority for fighting deflation today will in time bring about a significant resurgence of inflation.

How does the saying go? Out of the frying pan and into the fire?

David Gitlitz is chief economist of Trend Macrolytics LLC.

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