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Reviving the Economy Tests Convential Views on Inflation

August 21, 2009 at 12:00 AM EDT
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With the economy showing hints of a recovery, the threat of inflation is testing policy makers at the Federal Reserve as they work to determine how quickly to unwind emergency moves taken during the height of the financial crisis. Paul Solman reports.

JIM LEHRER: As we heard, Federal Reserve Chairman Bernanke defended some major government interventions of the past year, but those actions have stoked fears of inflation. And that’s the subject of a report by NewsHour economics correspondent Paul Solman. It’s part of his ongoing series on “Making Sense” of financial news.

PAUL SOLMAN, NewsHour economics correspondent: An Italian-American senior center in New Haven, Connecticut, just a year ago, the day after Lehman Brothers went up in smoke. But what had folks come here to talk to us about? Inflation.

SENIOR: The cost of living is so high, so I needed to go back to work to survive.

SENIOR: Food goes up. Your gas is going up.

PAT CORSO: It’s harder than it was last year. I used to get a pound of ditalini macaroni. It was 50 cents. It’s a dollar. It’s one dollar now.

BETTY ACABBO: That ditalini she’s taking about, I’ve seen it $1.39.



SENIOR: $1.39?

PAT CORSO: I wouldn’t buy that.

PAUL SOLMAN: That very same night, on both the New York Times’ Web page and ours, posts entitled, “Is it the end of the world as we know it?”

R.E.M. (singing): It’s the end of the world as we know it…

PAUL SOLMAN: Were we tumbling into a financial crisis of Great Depression-like proportions, with plunging prices in stocks and housing already having forced government bailouts of Bear Stearns, Fannie Mae, and Freddie Mac?

Yet despite all this, rising prices were still paramount to the minds of most folks here.

EMIDIO CAVALIERI: We were planning a trip to Italy with my wife, so we decided that we had to cut down a bit, so I left her home.

PAUL SOLMAN: The humor here, from macaroni to matrimony, suggested that oil and food price hikes and a rising budget deficit had folks more spooked about a declining dollar than almost anything else.

In Oakland, California, gloom-and-doom economist John Williams was so afraid of the buckling buck…

JOHN WILLIAMS, I buy gold coins as a hedge against inflation.

CHARLIE MAMMOSER, Northern California Coin Exchange: These are called gold eagles.

PAUL SOLMAN: Williams had taken us to his local gold dealer, Charlie Mammoser.

A lot of people like him, Charlie?

CHARLIE MAMMOSER: Yeah, there’s quite a lot of them actually, especially the way, you know, the economy’s been going, and the dollar’s been down, and oil’s been up, and gold’s been running crazy.

PAUL SOLMAN: What was gold at the time, per ounce?

CHARLIE MAMMOSER: Right now, gold is $750.10.

PAUL SOLMAN: The price had actually been higher, but Williams was unfazed.

JOHN WILLIAMS: Whether you buy it at $750, $700, $1,000, it’s going to be a buy over the long term, because long term we have a terrible inflation problem ahead of us.

Staving off deflation

PAUL SOLMAN: Mind you, at that very moment, the fear gripping government was of just the opposite: deflation. In fact, within a week, we killed the inflation report, which took us to New Haven and Oakland, because inflation just wasn't a story anymore. Consumers had suddenly frozen their spending. So had businesses. Prices were plummeting; banks, failing.

The economic story in the interim has been government saving the system from deflation, especially Fed Reserve Chairman Ben Bernanke, our lender of last resort.

BEN BERNANKE, Federal Reserve Chairman: Over the past year, the Federal Reserve has actively used all its powers and authorities to try to help this economy through this difficult time.

PAUL SOLMAN: Bernanke even vowed to fight deflation by threatening to drop money from a helicopter if need be. To historian Harold James, it was Bernanke's way of saying...

HAROLD JAMES, Princeton University: We know what we can do to stop deflations. There is something that can be done. We don't need to see these monetary contractions. If the worst comes to the worst, you can get into the helicopter and -- and spread the money.

PAUL SOLMAN: Just drop it on people?

HAROLD JAMES: Right. That's right.

PAUL SOLMAN: The Fed never went that far, but it sure began relieving sickly banks of their toxic debts fast, quickly transfusing vast amounts of money it created -- electronic Federal Reserves -- to reflate the financial system, prevent bank runs and bankruptcies.

Former Fed Vice Chair Alan Blinder.

ALAN BLINDER, former Federal Reserve vice chair: The Fed has had to put hundreds of billions of dollars of excess reserves into the system, which in normal times it would not have to do.

PAUL SOLMAN: Most abnormal of all, those hundreds of billions, while plausibly shoring up the banks and thus saving them from collapse, didn't actually make it back out into the economy.

ALAN BLINDER: What normally happens, banks get money, but they don't want to sit on the money. They use that as the basis for loans, and that's what makes the economy grow. But you can stop that process at stage one if you have panic-stricken banks, which we did have for a while, and to some extent still have. Now they get the money and they just sit on it; they don't lend it to anybody.


ALAN BLINDER: Why? Because they're afraid they won't get paid back.

Banks keep grip on federal reserves

PAUL SOLMAN: So what's happened to the nearly $1 trillion new dollars the Federal Reserve has created out of thin air, more than doubling its balance sheet and certainly suggesting good, old inflation?

ALAN BLINDER: If you ask, where in the world are these reserves? They're sitting in the bank accounts of commercial banks that have bank accounts at the Fed, just as if you and I were just holding money in our checking accounts.

PAUL SOLMAN: And just like our checking accounts, the Fed pays a bit of interest, 0.25 percent, for re-deposits at the Fed. But, we asked Brian Sack, who runs the Fed trading desk in New York, isn't the point of pumping reserves into the banks to get the money loaned out and moving through the economy?

BRIAN SACK, executive vice president, Federal Reserve Bank of New York: We're trying to encourage that process of boosting the flow of credit and making credit available on more accommodative terms.

PAUL SOLMAN: And that hasn't yet happened to the extent that you hope it will?

BRIAN SACK: Well, it has happened to some extent. I think we're seeing improvement in a lot of private asset markets. Mortgage rates are relatively low. Certain types of consumer credit markets seem to be coming back. So I think we're seeing some effects, but overall I think credit conditions are still quite tight, and, you know, we'd like to see further improvements in order to encourage economic growth.

PAUL SOLMAN: So the Fed has announced another $1.75 trillion of new purchases of assets from the banking system, Treasuries, mortgage-backed securities, Fannie Mae and Freddie Mac loans, replacing them with Federal Reserves, electronic money. It's what they were doing the day our cameras were there.

BRIAN SACK: The idea is, over time, those reserves will be put to work, in terms of buying securities or making loans, but currently a lot of them are resting at the banks.

Looming threat of inflation

PAUL SOLMAN: Not circulating, that is, not causing inflation. But so much money creation also raises the specter of inflation in the future. Former Fed economist Nick Perna.

NICK PERNA, Perna Associates: Between you, me and the lamppost, it shifts the focus away from worrying about deflation to worrying about inflation, which I think is a great thing to be worrying about rather than deflation.

PAUL SOLMAN: A "great thing" in a time of dangerously diving prices. But now the big question: Is the next fear again inflation, prices rising too fast?

So what happens when the banks start lending again? And if the new trillion dollars or more that the Fed has created actually flows through the economy, won't that inflate prices? Getting peanuts in interest from depositing the Fed's own money back at the Fed, the banks will want to lend it out to borrowers who will pay a lot more. And then?

NICK PERNA: Then the Fed has to start pulling it out. It's a very, very, very difficult task.

PAUL SOLMAN: Chairman Bernanke acknowledged as much in his NewsHour forum in Kansas City.

BEN BERNANKE: Once the economy starts to grow and begins to move ahead, then it will be very important for the Fed to unwind, raise interest rates, bring that credit back, bring the money back, so that we don't have an inflation problem down the road.

PAUL SOLMAN: In short, the Fed might actually offer banks a higher interest rate to hold onto Fed money, keep it out of circulation, or suck up the money by selling banks all those securities it bought during the crisis. But none of it will be easy, says MIT's Simon Johnson.

SIMON JOHNSON, MIT Sloan School of Management: It's a very tricky game they're playing. They're worried about the money getting out of control. If you pump money into any economy, even this economy, without limits, you don't quite know what's going to happen to the price level. The prices could jump up.

PAUL SOLMAN: And that, Simon says, would be inflation: prices jumping, dollars worth less and less.

But last question: Is there any real evidence to back up the fears of yesteryear? Well, the traditional measure of inflation, the Consumer Price Index, is down over the last year, which may have seniors feeling a bit more flush, until they find out their Social Security checks are also about to go down, reflecting the lower CPI.**

But the CPI moved up almost 1 percent at the beginning of the summer, not a good sign for ditalini prices.

JOHN WILLIAMS: With long term, gold would be my best bet.

PAUL SOLMAN: Meanwhile, in the year since we were last in Oakland, the price of gold -- that other indicator of inflation -- has risen some $200 an ounce, an annual increase of more than 25 percent.

The problem facing the Fed, then, is its ability to withdraw its excess reserves in time. And if it has to by selling off the troubled assets it's been buying with its newly minted money, will that drive the economy down once more?

SIMON JOHNSON: Who knows what will happen, Paul? We are in completely uncharted territory here.

PAUL SOLMAN: Stay tuned.

JIM LEHRER: Yes. And you can stay tuned on our Web site at, where you can use an inflation calculator to discover the buying power of a dollar for every year since 1913. Find the link on our "Making Sense" page.

**A Correction From Paul Solman -- Aug. 23, 2009

On Friday night's program, in a story on inflation, I reported the following:

"The traditional measure of inflation, the Consumer Price Index, is DOWN over the last year, which may have seniors feeling a bit more flush - until they find out their social security checks are also about to go down, reflecting the lower CPI."

But I seem to have been mistaken, according to a careful reading of the Social Security Handbook that I requested from retirement economist Larry Kotlikoff of Boston University. We'll try to have a definitive answer from Social Security itself on Monday, but right now my best guess is that benefit checks, starting in 2010, may well show no increase over this year's checks, but won't go DOWN. Read the rest of this correction on the Business Desk.