Enough Hot Air About Inflation

It isn’t our biggest concern right now.

Paul Krugman

Can we please stop worrying about inflation—at least for a few months? Since the onset of the financial crisis in 2008, there has been serious concern that the massive expansion of the Fed’s balance sheet, the central bank’s policy of zero interest rates, and the large stimulus (and ensuing deficits) would, by some iron law of economics, debase the currency, boost the government’s long-term borrowing costs, and ignite inflation. (Last year, I wrote about the debate over this topic between historian Niall Ferguson and economist Paul Krugman.)

By almost every measure—the price of gold being a notable exception—observed inflation and inflation expectations have remained remarkably contained since the fall of 2008. They have done so even as growth has reignited in the United States. And the evidence weighing in favor of deflation—or at least a serious lack of inflation—continues to mount. Last week, the Bureau of Labor Statistics reported that inflation, as measured by the Consumer Price Index, fell 0.1 percent in April. Over the last year, it has risen a tame 2.2 percent. Factor out volatile food and energy prices and the long-term trend was more heartening. In the last 12 months, the core index has risen just 0.9 percent, “the smallest 12-month increase since January 1966.” (Check out this inflation chart Krugman posted on his blog on May 19.)

What gives? There are certainly forces at work that are pushing in favor of inflation—the price of gold, the bounce in the price of commodities (look at the long-term charts of the Dow Jones-UBS Commodities Index), rapid growth in China and other emerging markets, and loose fiscal and monetary policy. But in the post-bust environment, other countervailing forces are weighing against inflation, especially in the world’s two largest economies: the United States and the eurozone. Even though America has rediscovered its capacity for growth, there’s still a lot of slack in the economy, as shown by the data on capacity utilization and unemployment. And it’s hard to identify things that are getting more expensive in the United States. The cost of housing may be stabilizing, but it isn’t rising. Energy? Nope. Oil prices have fallen in recent weeks.

The markets seem to be discounting the possibility that inflation will lead to higher interest rates and a debased U.S. currency. A chart of the trade-weighted dollar shows it has strengthened since 2008 and has rallied. Inflation expectations are contained, as shown by the yield on TIPS, government bonds that protect investors from inflation. The yield on the 10-year bond now stands at a paltry 3.2 percent. Here’s a five-year chart of the 10-year government bond; does that look like an inflationary environment?

Of course, every time there’s a crisis in the world, investors rush to buy the dollar and government bonds, which pushes interest rates down. And the latest crisis—the problems in Europe—has added another log to the deflation bonfire. The eurozone’s economy is about as large as that of the United States. But it has hit a rough patch. In response to the crisis, the European Central Bank is expanding its balance sheet, as the Federal Reserve did in 2008 and 2009. But Europe is pursuing an entirely different fiscal policy than America did. Rather than cut taxes and massively increase spending on a temporary basis, European governments are embracing austerity. Germany, Spain, Greece, and Portugal are slashing government spending and raising taxes. These are contractionary fiscal policies that will likely lead to less consumer and business activity, slower growth, and falling prices. Still freaked out about inflation years after the hyperinflation of the 1920s, Europe may be setting itself up for some deflation.

 It’s possible that the power of rising consumption and production in China, India, and other emerging markets can ignite inflation. But so far, it doesn’t seem to be doing so. And the accumulation of market and observable evidence seems to be sinking in at the U.S. organization charged with maintaining price stability. At its April meeting, the Federal Reserve’s Open Market Committee did its usual fretting and discussed the need to raise interest rates and sell off assets as a means of warding off inflation. But it concluded that inflation was largely under control. “In light of stable longer-term inflation expectations and the likely continuation of substantial resource slack, policymakers anticipated that both overall and core inflation would remain subdued through 2012, with measured inflation somewhat below rates that policymakers considered to be consistent over the longer run with the Federal Reserve’s dual mandate.”

It’s possible that the FOMC’s statement, along with the market data I’ve cited, are signs of dangerous complacency. The Fed and the markets have been wrong about these things before. And some of the anti-inflation data points are predictable hair-trigger reactions. But it could also be that on the long list of global economic risks, inflation shouldn’t be near the top.

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