If high inflation is not here yet, why should the Fed change course?

Editor’s Note: With all eyes on the Federal Reserve this week as they ended their bond-buying program, we’ve been highly attuned to their decision making process, and in particular, how their expectations as a central bank are different from those of other central banks.

The Fed has to fulfill two mandates — maintaining stable prices and full employment — while the European Central Bank, for example, and the Bank of Japan, which just increased their quantitative easing purchases Friday, only have to worry about one: Keeping inflation in check.

The damned-if-we-do, damned-if-we-don’t pressure that comes along with the Fed’s two, often divergent goals, is the subject of econo-crooner Merle Hazard’s latest central bank ballad, “Dual Mandate.”

Merle’s lyrics, which you can read in full here, illustrate the left-right split coloring this monetary debate.

The right says I should tighten up on credit
To keep the risk of inflation nice and low
But the left, and many economic scholars, are urgin’ me to print more dollars
I’m torn between the two ways I could go

On the left is New York Times columnist Paul Krugman, who doesn’t think the Fed is achieving either of their mandates and would have liked to have seen them continue their bond buying last longer since employment rates and wages are still depressed.

“The average Joe’s not overjoyed if he’s destitute, and unemployed,” Merle sings.

“That’s correct,” Columbia professor Charles Calomiris tells Paul Solman, “But we have to ask: How is he benefiting from the current environment of high stocks, high bond prices?” Some economists have argued that loose monetary policy has simply created a bubble on Wall Street (and indeed, stocks plunged in the summer of 2013 when the Fed hinted it was ending quantitative easing), while leaving Main Street out in the cold. “If he has a savings account in the bank,” Calomiris continues about the average Joe, “he’s earning very little interest.”

Easy monetary policy, monetary hawks fear, can contribute to rising inflation, which, if above the Fed’s 2 percent target, would violate their mandate. “Ultimately,” Calomiris continues, “inflation is a very regressive tax that mainly harms low income people.”

But as Paul Krugman would argue, we haven’t seen dangerous inflation — it’s still below the Fed’s target. So what’s all the huff about inflation, especially when employment is still not where it needs to be?

Yes, employment is important, Calomiris says. In fact, he argues, it’s all conservatives really care about. The trade-off between policy mandates that Merle’s “Dual Mandate” bemoans doesn’t actually exist, Calomiris thinks, because controlling inflation is really just a means to achieving maximum employment.

The danger, Calomiris fears, is that the Fed’s bloated balance sheet will lead to inflation, and the Fed won’t be able to deal with it in time, and then where will the unemployed be? “Look at where inflation’s gotten out of control,” he says, pointing to Brazil in the 1980s. “You’ve actually seen some revolutionary responses by low income people to it.”

Calomiris makes his point about easy money to Paul Solman in Wednesday’s broadcast, which you can watch below:

To understand more about why we should fear inflation, read Calomiris’ edited conversation with Paul Solman below.

— Simone Pathe, Making Sen$e Editor

Paul Solman: So the philosophy of the Federal Reserve is to have a dual mandate: worry about unemployment on the one hand, and worry about inflation on the other. Makes sense doesn’t it?

Charles Calomiris: You might say it would make more sense to only worry about employment in the long run. That’s all we really care about. But the reason we focus on inflation, and should focus more on it, is because it’s a tool, a tactic, to achieve full employment.

All that we care about, ultimately, is employment and production. But the point is that if the Fed were focused on employment and production too much, it would end up not achieving, in some long-run sense, its goals in employment and production.

People like [former Fed chair] Paul Volcker and myself, and many others who’ve called for the Fed to focus much more on inflation as a targeting variable, are arguing that by doing so, they’ll achieve more employment in the long term. So it’s really a strategic question, not a question of what the objectives should be.

But even in the short run, when we’re targeting inflation, which is the right thing to be focused on to achieve long-run employment and production maximization, we might want to not so aggressively target inflation that we cause unnecessary short-term volatility in the labor markets.

Paul Solman: So the idea is you keep inflation low to keep the economy humming, and then there’ll be more employment, more production, yes?

Charles Calomiris: Absolutely. Long-term low inflation has been clearly shown to maximize employment and production.

But if you start doing things that are very unpredictable, you also can cause more instability and unemployment and inflation as a result of the confusion you create. So part of the story is not just that we want to actually have prices fairly stable, but we also want people to understand what the monetary authority’s doing.

Right now, many people, including myself, have a hard time figuring out what the Fed’s really thinking and what their short-term objectives are. The Fed has been changing its views about whether unemployment is an adequate measure of the condition of the labor market. Now it’s not just unemployment – it’s labor participation – it’s like it’s whatever seems convenient.

You can take any piece of economic news and spin it one way or the other. Oil prices are low – that sounds like great news. But then people say: Oh, that means the oil market’s worried about things. It could be. Or the dollar’s high – that means our exports are going to fall. But the problem, of course, is that you can tell the story the opposite way too.

What’s worrying is when the Fed seems to go back and forth and say, “Oh, today we’re going to look at the dollar. Tomorrow we’re going to look at consumer confidence. The next day we’re going to look at the… you name it.” You get the feeling that they don’t really have a clear objective that I can rely on, or that other people can rely on, to plan our lives.

Paul Solman: But why in the world should the Fed worry about inflation now? Inflation is going down, actually, in the last producer price index report, and it’s been hovering at 1.5 percent or so for a year or more.

Charles Calomiris: I don’t think that the Fed should be worrying about inflation as something that’s likely to change a lot over the next six months or year at all. And, by the way, inflation forecasts are pretty stable going out about 10 years at around 2 percent. So the Fed, at least currently, has the market’s confidence that it is going to achieve somewhere between 1.5 and 2 percent inflation for the foreseeable future.
The problem is with the Fed’s balance sheet, how much stuff it has bought…

Paul Solman: And created new money to buy it.

Charles Calomiris: Exactly. The Fed has purchased something like $1.7 trillion of mortgage-backed securities and a very large amount of long-term Treasury securities. It’s grown its balance sheet from under a trillion to four times that, just in a few years. This is a pretty unprecedented change.

The reason that hasn’t caused inflation yet and might never cause inflation is because the private sector hasn’t multiplied that Federal Reserve money creation by creating deposits and loans as it normally would. There’s normally a ratio of the private sector’s money creation relative to the Fed’s. But that relationship has temporarily broken down, as it has sometimes in the past.

When we go back to that ratio or get closer to it, all of a sudden we have a major risk of inflation. And then the question is: Well, can the Fed move quickly enough to shrink its balance sheet or do something else to prevent that inflation?

Now, the problem here is the Fed has recognized, I think, that it’s going to be difficult to shrink its balance sheet. In fact, it’s announced that the $1.7 trillion mortgage-backed securities that have over 20-year maturities, it’s not planning to sell at all. So that makes you kind of wonder: How is the Fed going to react to the normalization of that ratio between the private money and the Fed’s money?

Paul Solman: In other words, how’s the Fed going to react if suddenly there is inflation and they aren’t going to try to lower the money supply by selling those mortgage-backed securities they’ve got in the market?

Charles Calomiris: Precisely. Now, the Fed has said it has some other tools up its sleeve – like paying interest on reserves – these are things that haven’t been really tried before.

There are two questions. One is a technical question of whether, given how the Fed has loaded its balance sheet, it’s going to be able to really shrink that balance sheet as needed, or come up with some alternative fancy new methods that are going to substitute for that. And then the other question that I think is really very germane is in this highly politicized Fed environment, will the Fed really be willing to do that?

Janet Yellen was just pictured with some unemployed people, by the way. What message is she sending out? And why would a Fed chairman do this – it’s unprecedented. And I think this is a symbol, an indicator, of how highly charged the political environment is right now that could weigh against the Fed doing the right thing.

But Where’s the Inflation?

Paul Solman: I’ve been waiting for you to say: What do you mean, there’s no inflation? There’s inflation in the stock market, or in the commodities market, or in the real estate market. There is inflation, but we just don’t see it in prices.

Charles Calomiris: Absolutely, asset prices have been inflated. For example, farm land is probably 30 percent, on average, overvalued. I think the stock market was overvalued, which is why it has come down. Some elements of the bond market, too, variable annuity pricing, real estate, especially some commercial real estate.

There’s research looking at the effect of monetary policy on asset price bubble formation, and it’s completely conclusive. The evidence is when the Fed expands the money supply, the behavior toward risk becomes much more forgiving. People are willing to bear risk for less compensation. The riskiness of loan portfolios and the quantity of lending tends to go up.
The quantity of lending hasn’t really gone up because regulation, especially capital requirements on banks and other things, have kept lending back so far. But that’s a temporary phenomenon and when that phenomenon reverses, you’re going to get the private money creation relative to the Fed’s balance sheet restored to its more average historical relationship.

Paul Solman: But right now, the bond market is forecasting an inflation rate of less than 2 percent over the next 10 years in this country. Are you suggesting that the bond market is wrong and you’re right to be worried?

Charles Calomiris: Being worried isn’t the same as forecasting a higher average inflation rate. I’m worried that inflation could go higher than 2 percent if the Fed doesn’t, on a timely basis, exit from this very loose monetary policy when it needs to. My own feeling is this is a big risk. Doesn’t mean it’s necessarily going to happen.

My view was that QE3 was actually not a good bet, precisely because it raised the possibility of a big inflation risk for a very small payoff. But that’s not the same as saying that I know or even am willing to forecast that the Fed will definitely let us down.

Paul Solman: I wasn’t talking to you a few years ago, but I’m betting that you were predicting a significant rise in inflation could be right around the corner, no?

Charles Calomiris: Yes, and it could have been right around the corner. The question is when will we get back to that growth in bank lending? I wasn’t forecasting whether it was going to happen in two years or four years or six years. The point is, it hasn’t happened yet. When it happens, that’s when the Fed gets tested.

Paul Solman: So do you feel a little contrite, perhaps, about having been a fiscal Chicken Little?

Charles Calomiris: No, I don’t feel contrite because the Fed has justified in its behavior and it statements exactly what I predicted would happen; that is that the Fed is not able to shrink its balance sheet and they say they have other tools. The point is the risk is there, which was my point all along.

Calomiris graded Ben Bernanke’s tenure at the Fed on the NewsHour in January.