Inflation is now low in every industrial country, and thecombination of high unemployment and slow GDP growth removes the usual sourcesof upward pressure on prices. Nevertheless, financial investors areincreasingly worried that inflation will eventually begin to rise, owing to thelarge expansion of commercial bank reserves engineered by the United StatesFederal Reserve and the European Central Bank (ECB). Some investors, at least,remember that rising inflation typically follows monetary expansion, and theyfear that this time will be no different.
Investors have responded to these fears by buying gold,agricultural land, and other traditional inflation hedges. The price of goldrecently reached a four-month high and is approaching $1,700 an ounce. Pricesper acre of farmland in Iowaand Illinoisrose more than 10% over the past year. And the recent release of the US FederalReserve Board’s minutes, which indicate support for another round ofquantitative easing, caused sharp jumps in the prices of gold, silver, platinum, and other metals.
But, unlike private investors, Fed officials insist thatthis time really will be different. They note that the enormous expansionof commercial banks’ reserves has not led to a comparable increase in thesupply of money and credit. While reserves increased at an annual rate of 22%over the past three years, the broad monetary aggregate (M2) that most closelytracks nominal GDP and inflation over long periods of time increased at lessthan 6% over the same three years.
In past decades, large expansions of bank reserves causedlending surges that increased the money supply and fueled inflationary spendinggrowth. But now commercial banks are willing to hold their excess reserves atthe Fed, because the Fed now pays interest on those deposits. The ECB also paysinterest on deposits, so it, too, can in principle prevent higher reserves fromleading to an unwanted lending explosion.
The Fed’s ability to pay interest is the key to what itcalls its “exit strategy” from previous quantitative easing. When the economicrecovery begins to accelerate, commercial banks will want to use the largevolume of reserves that the Fed has created to make loans to businesses andconsumers. If credit expands too rapidly, the Fed can raise the interest ratethat it pays on deposits. Sufficiently high rates will induce commercial banksto prefer the Fed’s combination of liquidity, safety, and yield to expandingthe quantity of private lending.
That, at any rate, is the theory; no one knows how it wouldwork in practice. How high would the Fed – or the ECB, for that matter – haveto raise the interest rate on deposits to prevent excessivegrowth in bank lending? What if that interest rate had to be 4% or 6% or even8%? Would the Fed or the ECB push its deposit rate that high, or would it allowa rapid, potentially inflationary lending growth?
The unusual nature of current unemployment increases therisk of future inflation still further. Nearly half of the unemployed in the US, forexample, have now been out of work for six months or longer, up from thetraditional median unemployment duration of just 10 weeks. The long-termunemployed will be much slower to be hired as the economy recovers than thosewho have been out of work for a much shorter period of time.
The risk, therefore, is that product markets will tightenwhile there is still high measured unemployment. Inflation will begin inproduct markets, rather than in the labor market. Businesses will want toborrow, and banks will want to expand their lending. Under these conditions,the Fed will want to raise the interest rate to prevent an acceleration ofinflation.
But, if the unemployment rate is then still relatively high– say, above 7% – some members of the Fed’s Open Market Committee may arguethat the Fed’s dual mandate – low unemployment as well as low inflation –implies that it is too soon to raise interest rates.
There could also be strong pressure from the US Congressnot to raise interest rates. Although the Fed’s legal “independence” means thatthe White House cannot tell the Fed what to do, the Fed is fully accountable toCongress. The recent Dodd-Frank financial-reform legislation took away some of the Fed’s powers, and thelegislative debate surrounding the bill indicated that there could be widesupport for further restrictions if Congress becomes unhappy with Fed policy.
Politicians’ desire to keep interest rates low in order toreduce unemployment is often in tension with the Fed’s concern to act in atimely manner to maintain price stability. The large number of long-termunemployed may make the problem more difficult this time by causing theunemployment rate to remain high even when product markets are beginning toexperience rising inflation.
If that happens, Fed officials will face a difficultchoice: tighten monetary policy to stemaccelerating price growth, thereby antagonizingCongress and possibly facing restrictions that make it difficult to fightinflation in the future; or do nothing. Either choice could mean a higherfuture rate of inflation, just as financial markets fear.
Although the ECB does not have to deal with directlegislative oversight, it is now clear thatthere are members of its governing board who would oppose higher interestrates, and that there is political pressure from government leaders and financeministers to keep rates low.
Rising inflation is certainly not inevitable, but, in boththe US and Europe,it has become a risk to be reckoned with.