Amid a fledgling recovery, fading fiscal stimulus and a ballooning budget deficit, President Obama faces some tough decisions: Should he push for another stimulus package to assure continued growth? Or should he try to rein in the deficit and risk killing the recovery? Obama will be traveling a dangerous trail, but he can take comfort knowing that Federal Reserve Chairman Ben Bernanke will be riding shotgun.
Given the way the inflation outlook is shaping up, it’s a good bet the Fed will be able to provide the economy with plenty of support in the coming year, perhaps more than the financial markets now expect. Despite recent rising employment and retail sales — signs that the economy is on the mend — the Fed will be very hesitant to start tightening monetary policy as long as the threat of a debilitating Japanese-style deflation remains. Deflation, or falling prices, discourages business expansion, and consumers tend to delay spending as they wait for cheaper deals. Deflation also creates an especially onerous problem for central bankers: Falling prices push up the real, or inflation-adjusted, cost of borrowing — the opposite of what policymakers would want to combat weak demand. People who owe money have to pay back loans with dollars that will buy more goods than the dollars they borrowed.
During their March 16 meeting, Fed policymakers expressed some surprise at the softness in prices, according to the minutes released on April 8. Deep discounts in cars and consumer goods may have been partly responsible for the March consumer price index which shows that core inflation dipped to a six-year low of 1.1 percent (see chart). Core inflation ignores the short-term ups and downs in energy and food prices. Over the past six months, core inflation is running at a mere 0.6 percent, measured at an annual rate, and many economists expect it to slide close to zero by year end. Historically, inflation continues to fall for up to two years after the end of a recession. The last time price trends were as weak as they are now, then-Fed Governor Bernanke was leading the alert in a 2002 speech titled, "Deflation: Making Sure "It" Doesn't Happen Here."
This time, the downward pressure on prices is even more intense, reflecting an unusually high degree of unused labor and other productive resources. Economists know that any substantial upward pressure on prices cannot take root until overall demand is strong enough to strain the productive capacity of workers and facilities. Consequently, some believe the Fed may not begin to lift interest rates until this time next year, especially with the anticipated fiscal policy shifting from a boost to a drag.
Based on the Congressional Budget Office’s method for estimating the output gap — the difference between the economy’s actual output, or GDP, and the potential output that could be achieved at full employment— the amount of slack is so great that the economy could grow 5 percent this year and next before bridging the divide. Assuming the broadly believed forecast that growth will average about 3.3 percent per year over the next few years, the difference would not be made up until 2014. If the gap is as wide as these numbers suggest — and there’s no guarantee that it is — the Fed has plenty of leeway to accept a period of strong growth in the coming quarters with little fear that it would lead to unacceptably high inflation.
The threat of deflation is not just a U.S. concern. The February measure of core consumer inflation in the 30 nations that make up the Organization for Economic Cooperation and Development, dipped to a record-low 1.5 percent. Prices in Japan have been falling for more than a year, and the core rate in the eurozone slid to new low of 0.8 percent, down nearly two percentage points since mid-2008. Deflation has already arrived in some eurozone countries, including Ireland and Portugal, and the yearly rate in Spain appears ready to slip below zero very soon. Economists at JPMorgan Chase note that, because the eurozone recovery is off to such a slow start, the output gap has not closed much, even in relatively better-off economies such as Germany and France.
A few Fed policymakers worry that the amount of slack in the economy can be a moving target, noting that miscalculations in the 1970s contributed to a surge in inflation. Business outlays for equipment have been slashed so dramatically that there may not be as much idle production capacity as the CBO suggests. Plus, the jobless rate consistent with full employment and stable inflation may have risen well above the generally accepted level of about 5 percent. That would mean inflation could begin to take hold at a higher level of unemployment.
Bernanke and other Fed officials who see the Fed’s target interest rate remaining "exceptionally low" for "an extended period" are not deaf to these arguments. But as a student of Depression-era economics, Bernanke knows better than most that deflation can be crippling and difficult to escape. Right now there’s a 50-50 chance that the Fed will lift its target rate to at least 0.5 percent by September. However, Bernanke has often noted that tightening policy too early was a fateful misstep not only by Japan in the 1990s, but by the U.S. in the 1930s. By September, economists expect the jobless rate to be still above 9 percent and core inflation to be heading toward zero. That would present a strong case for the Fed to hold off tightening policy until the economy is growing fast enough to assure a sustainable recovery and stable prices. If Bernanke & Co. can accomplish that, new fiscal stimulus may not be necessary, and solid growth will generate the tax revenues needed to help manage the deficit.