Is Inflation Returning?

Martin Feldstein

29 August 2012
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CAMBRIDGEInflation is now low in every industrial country, and the combination of high unemployment and slow GDP growth removes the usual sources of upward pressure on prices. Nevertheless, financial investors are increasingly worried that inflation will eventually begin to rise, owing to the large expansion of commercial bank reserves engineered by the United States Federal Reserve and the European Central Bank (ECB). Some investors, at least, remember that rising inflation typically follows monetary expansion, and they fear 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 gold recently reached a four-month high and is approaching $1,700 an ounce. Prices per acre of farmland in Iowa and Illinois rose more than 10% over the past year. And the recent release of the US Federal Reserve Board’s minutes, which indicate support for another round of quantitative easing, caused sharp jumps in the prices of gold, silver, platinum, and other metals.
 
 
 
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But, unlike private investors, Fed officials insist that this time really will be different. They note that the enormous expansion of commercial banks’ reserves has not led to a comparable increase in the supply 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 closely tracks nominal GDP and inflation over long periods of time increased at less than 6% over the same three years.
 
 
 
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In past decades, large expansions of bank reserves caused lending surges that increased the money supply and fueled inflationary spending growth. But now commercial banks are willing to hold their excess reserves at the Fed, because the Fed now pays interest on those deposits. The ECB also pays interest on deposits, so it, too, can in principle prevent higher reserves from leading to an unwanted lending explosion.
 
 
 
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The Fed’s ability to pay interest is the key to what it calls its “exit strategy” from previous quantitative easing. When the economic recovery begins to accelerate, commercial banks will want to use the large volume of reserves that the Fed has created to make loans to businesses and consumers. If credit expands too rapidly, the Fed can raise the interest rate that it pays on deposits. Sufficiently high rates will induce commercial banks to prefer the Fed’s combination of liquidity, safety, and yield to expanding the quantity of private lending.
 
 
 
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That, at any rate, is the theory; no one knows how it would work in practice. How high would the Fed – or the ECB, for that matter – have to raise the interest rate on deposits to prevent excessive growth in bank lending? What if that interest rate had to be 4% or 6% or even 8%? Would the Fed or the ECB push its deposit rate that high, or would it allow a rapid, potentially inflationary lending growth?
 
 
 
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The unusual nature of current unemployment increases the risk of future inflation still further. Nearly half of the unemployed in the US, for example, have now been out of work for six months or longer, up from the traditional median unemployment duration of just 10 weeks. The long-term unemployed will be much slower to be hired as the economy recovers than those who have been out of work for a much shorter period of time.
 
 

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The risk, therefore, is that product markets will tighten while there is still high measured unemployment. Inflation will begin in product markets, rather than in the labor market. Businesses will want to borrow, and banks will want to expand their lending. Under these conditions, the Fed will want to raise the interest rate to prevent an acceleration of inflation.
 
 
 
 
But, if the unemployment rate is then still relatively high – say, above 7%some members of the Fed’s Open Market Committee may argue that the Fed’s dual mandatelow unemployment as well as low inflationimplies that it is too soon to raise interest rates.
 
 
 
 
There could also be strong pressure from the US Congress not to raise interest rates. Although the Fed’s legalindependencemeans that the White House cannot tell the Fed what to do, the Fed is fully accountable to Congress. The recent Dodd-Frank financial-reform legislation took away some of the Fed’s powers, and the legislative debate surrounding the bill indicated that there could be wide support for further restrictions if Congress becomes unhappy with Fed policy.
 
 
 
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Politicians’ desire to keep interest rates low in order to reduce unemployment is often in tension with the Fed’s concern to act in a timely manner to maintain price stability. The large number of long-term unemployed may make the problem more difficult this time by causing the unemployment rate to remain high even when product markets are beginning to experience rising inflation.
 
 

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If that happens, Fed officials will face a difficult choice: tighten monetary policy to stem accelerating price growth, thereby antagonizing Congress and possibly facing restrictions that make it difficult to fight inflation in the future; or do nothing. Either choice could mean a higher future rate of inflation, just as financial markets fear.
 

 
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Although the ECB does not have to deal with direct legislative oversight, it is now clear that there are members of its governing board who would oppose higher interest rates, and that there is political pressure from government leaders and finance ministers to keep rates low.
 
 
 
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Rising inflation is certainly not inevitable, but, in both the US and Europe, it has become a risk to be reckoned with.
 
 


Martin Feldstein is Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982-1984, and is currently a member of the President's Council on Jobs and Competitiveness, as well as a member of the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the National Committee on United States-China Relations.
 



Markets Insight

August 29, 2012 12:11 pm

 
Shake off the addiction to Fed stimulus
 
By Jim Paulsen

Monetary policies are undergoing significant changes on both sides of the Atlantic. In the US, perhaps for the first time in this recovery, the Federal Reserve seems increasingly uneasy with additional monetary easing actions.



In the eurozone, on the other hand, after almost two years of championing fiscal austerity and only reluctantly employing monetary easing in the face of an ever widening crisis, the case for broader policy stimulus seems to be rapidly gaining support.



In our view, what has caused policy regimes on both sides of the pond to abruptly shift is the recent recognition of two major events – the Fed is out of bullets and Germany and France are nearing a recession.



Oddly enough, although these events sound frightening, they may finally push monetary policies in both regions of the world towards more appropriate and beneficial outcomes.




The eurozone crisis is about the incompatibility of monetary union without fiscal union. How does one choose an appropriate monetary policy when member countries face very diverse economic conditions? Since the inception of this crisis, the answer has been to consistently align European Central Bank policy with the needs of leadership in the regionthat is, primarily with Germany.





Consequently, until last autumn, despite ever worsening economic conditions throughout many of the periphery economies, since German economic growth was accelerating, ECB monetary policy remained restrictive. Even worse, an aggressive fiscal austerity programme was adopted. This approach did not work for US president Herbert Hoover in 1929. Nor has it worked in Europe today.




By last autumn, however, conditions in Germany also worsened, starting a process of eurozone economic alignment. As German attitudes about their own economic fate darkened, monetary policy was abruptly altered as new ECB president Mario Draghi promptly lowered interest rates and began expanding the ECB balance sheet. Today, for the first time since the crisis began, the eurozone has both a monetary and an economic union.




Greece and Germany are finally on the same economic page with the same economic goalspromoting growth. A unification of economic conditions across the eurozone is increasingly producing unified support for ECB monetary accommodation (and has also lessened aggressive calls for fiscal austerity) which gives the region the best chance yet of improving its economic outlook.




Unlike the ECB, the Fed has been in persistent easing mode since the 2008 recession. Only recently, and despite the 2012 US economic soft patch and renewed eurozone fears, has the Fed seemed somewhat reluctant to undertake yet another round of quantitative easing. Why?


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Could it be because it realises it is “effectivelyout of bullets? With $1.5tn in excess US bank reserves, is anyone really suffering from a lack of liquidity? And, with record low mortgage yields, who is being held back by oppressive interest rates?




The Fed may yet decide to undertake QE3. But would it really do any good? Did QE2 and Operation Twist provide successful outcomes? While they may have helped on the margin, despite almost constant and massive monetary stimulus throughout this recovery, there remains considerable angst surrounding the speed of real gross domestic product growth and the pace of job creation. By repeating round after round of QE when liquidity is already in surplus and interest rates are already at record lows, US monetary policy could be described by the old popularised definition of insanity – “doing the same thing over and over and expecting different results”.




The Fed may sense as much which could be why it is taking time to consider another easing round. Encouragingly, Fed reluctance and inactivity might represent the best outcome for US monetary policy. While economic fundamentals (eg, debt burdens) have improved significantly in the past couple of years due in part to past Fed actions, what is still lacking is economic confidence.



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The best outcome would be if the US economy recovered from its soft patch and the stock market rose to new recovery cycle highs while the Fed stood down. An unassisted economic and stock market revival would boost confidence by creating a sense of a much more sustainable, less monetarily addicted economy.




For the past couple of years, monetary policies on both sides of the pond have arguably been misaligned. The ECB has been overly restrictive killing economic growth and the Fed has been overly accommodative killing confidence.


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Fortunately, bad things have happened which may bring about good results. Germany is headed for recession and the US Federal Reserve is out of bullets
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Finally, some good news.


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Jim Paulsen is chief investment strategist at Wells Capital Management


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Copyright The Financial Times Limited 2012



An Autumn Abyss?
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Joschka Fischer
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29 August 2012
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BERLIN In the coming months, several serious regional economic and political crises could combine into one mega-watershed, fueling an intense global upheaval. In the course of the summer, the prospect of a perilous fall has become only more likely.
 
 
 
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The drums of war are being banged ever more loudly in the Middle East. No one can predict the direction in which Egypt’s Sunni Islamist president and parliamentary majority will lead the country.
 
 
 
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But one thing is clear: the Sunni Islamists are decisively altering the region’s politics. This regional re-alignment need not be necessarily anti-Western, but it surely will be if Israel and/or the United States attack Iran militarily.
 
 

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Meanwhile, civil war is raging in Syria, accompanied by a humanitarian catastrophe. To be sure, President Bashar al-Assad’s regime will not survive, but it is determined to fight until the end. Syria’s balkanization among the country’s diverse ethnic and religious groups is a clearly predictable result.
 
 
 
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Indeed, a Bosnia-type scenario can no longer be excluded, while the prospect of the Syrian government’s loss of control over its chemical weapons poses an immediate threat of military intervention by Turkey, Israel, or the US.

 
 
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Moreover, the Syrian civil war has become a proxy in an openly declared battle for regional hegemony between Iran on one side and Saudi Arabia, Qatar, Turkey, and the US on the other. Staying on the sidelines of this Arab-Western coalition, Israel is playing its cards close to its chest.
 
 
 
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Iran, for its part, has proclaimed Syria an indispensable ally, and is determined to prevent regime change there by all available means. Does that mean that Hezbollah’s militias in neighboring Lebanon will now become directly involved in Syria’s civil war? Would such intervention revive Lebanon’s own long civil war of the 1970’s and 1980’s? Is there a threat of a new Arab-Israeli war hanging over the Middle East? And, as Kurds inside and outside of Syria grow more assertive, Turkey, with its large and long-restive Kurdish population, is also growing restive.


 
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At the same time, the regional struggle currently playing out in Syria is becoming increasingly entangled with the other major source of war sounds: Iran’s nuclear program. Indeed, parallel to the Syrian drama, the rhetoric in the confrontation between Israel and Iran over the program has become dramatically harsher.
 
 

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Both sides have maneuvered themselves into a dead-end. If Iran gives in and agrees to a sustainable diplomatic solution, the regime will lose face on a critical domestic issue, jeopardizing its legitimacy and survival. From the regime’s point of view, the legacy of the 1979 Islamic revolution is at stake.



 
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But the international sanctions are hurting, and Iran risks losing Syria. Everything points to the regime’s need for successnow more than ever concerning its nuclear program.
 
 

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Similarly, Israel’s government has backed itself into a domestic policy trap of its own. Prime Minister Binyamin Netanyahu and Defense Minister Ehud Barak cannot accept a nuclear-armed Iran. They do not fear a nuclear attack against Israel, but rather a nuclear arms race in the region and a dramatic shift in power to Israel’s disadvantage. From their point of view, Israel must either convince the US to attack Iran and its nuclear plants or take on the maximum risk of using its own military forces to do so.
 
 
 
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Both sides have substantially reduced their options, thereby limiting the possibility of a diplomatic compromise. And that means that both sides have stopped thinking through the consequences of their actions.
 
 
 
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Everywhere there is talk of a “military option,” which means air strikes. But, while advocates speak of a limitedsurgical operation,” what they are really talking about is the start of two wars: an aerial war, led by the US and Israel, and an asymmetric war, led by Iran and its allies.
 

 
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And what if this “military optionfails? What if Iran becomes a nuclear power, the region’s democratic movements are swept away by a wave of anti-Western Islamic solidarity, and the Iranian regime emerges even stronger?
 
 
 
 
Iran, too, evidently has not thought its position through to its logical conclusion. What does it stand to gain from nuclear status if it comes at the cost of regional isolation and harsh United Nations sanctions for the foreseeable future? And what if it triggers a regional nuclear arms race?
 

 
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A war in the Persian Gulf – still the world’s gas station – would affect oil exports for some time, and energy prices would skyrocket, dealing a severe blow to a global economy that is teetering on the brink of recession.
 
 
 
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China, already in economic trouble, would be hit hardest, along with the whole of East Asia. With the US also economically weakened and facing a presidential election, America’s leadership ability would be seriously constricted. And could a weakened Europe cope with an oil shock at all? A regional and global security shock caused by asymmetric warfare could add still further to the world economy’s troubles, causing exports to slump even more.
 

 
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Respice finem! (“Consider the end”), the Romans used to say. World leaders need to take this timeless wisdom to heart. And that applies doubly to Europeans. It would be absurd if we had to suffer a real catastrophe again in order to understand what European integration has always been about.
 
 
 
 
 
Joschka Fischer was German Foreign Minister and Vice Chancellor from 1998-2005, a term marked by Germany's strong support for NATO’s intervention in Kosovo in 1999, followed by its opposition to the war in Iraq. Fischer entered electoral politics after participating in the anti-establishment protests of the 1960’s and 1970’s, and played a key role in founding Germany's Green Party, which he led for almost two decades.


 
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Copyright Project Syndicate - www.project-syndicate.org




August 28, 2012 6:46 pm
 
Bernanke should show some humility
 
By Bob Corker

You don’t have to watch the morning financial news or read the newspapers for long before realising that the day’s market activities will once again be driven by a “will they or won’t theydebate over the US Federal Reserve. Almost every day begins and ends with extensive debate on the same questions: what will the Fed do next? Will there be another round of quantitative easing?



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This week is yet another example, with global equity and bond markets now not debating macroeconomic fundamentals but instead placing bets on what Ben Bernanke will or won’t say in Jackson Hole on Friday. We are getting to the point where this question, and Mr Bernanke’s Fed itself, are becoming unhealthy distractions from improving our free market system and engaging in fundamental policy debates.


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Close Fed-watching by the markets is to be expected on days around policy announcements by the Federal Open Market Committee. And it is a sign of a healthy market when there are movements in bond prices in response to new pieces of economic data, such as unemployment figures or gross domestic product. There is of course nothing unusual about investors adjusting their expectations of interest rates as new information becomes available.



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But we are faced with a troubling dynamic where bad economic news is good for stocks because it means more cheap money is on the way and good economic news is bad for stocks because it means less money will be printed.




A big part of the problem is that the US Congress has given the Fed an overly broaddual mandate” of price stability and full employment. In 1978 Congress congratulated itself for “ending unemployment” via its passage of the Humphrey-Hawkins Act, which added full employment to the Federal Reserve’s existing mandate. This approach has not only proved unsound. It undermines the free market system, allows Congress to use the central bank as a scapegoat while avoiding tough policy decisions, and creates Fed addicts in our financial markets.




We are one of the only developed countries in the world that has such a mandate. The European Central Bank, the Bank of England and the Bundesbank, to name but a few examples, all have single mandates.




Over the past 30 years a lot of thought has been given to the question of what role a central bank should play in a developed economy. Since the financial crisis, the focus has returned to the proper role of monetary policy and the notion that central banks should provide utility services such as money clearing and transfers, serve as an emergency lender of last resort at a penalty rate in times of crisis, and maintain a money supply that provides for stable prices while guarding against inflation. The maintenance of full employment in an economy as a completely separate task from price stability is much too complex for the blunt tools of monetary policy. Even members of the Fed have begun to embrace the notion that what the Fed does best is maintain price stability, with James Bullard, the St Louis Fed president, recently saying “it’s OK to go to the single mandate” and that the Fed should focus on “providing stable prices to get the best employment outcomespossible.




I hope that in the coming years Congress will make the necessary changes to our central bank’s charter. But the blame does not rest solely with Congress. It would be helpful to have a Fed chairman who acted with a greater sense of humility about what monetary policy can achieve. Mr Bernanke’s comfort with managing long-term interest rates and his unwillingness to stand up and say that there are limits to what monetary policy can accomplish is disturbing, to say the least. We need to do better.




Ultimately, Congress should fix the Fed’s flawed dual mandate. In the meantime, though, we should set the following test for the next nominee to be the Fed chairman: do you see limits to monetary policy and will you stop punishing savers?




We need a Federal Reserve that will help, not hinder, our country’s vital transformation to an economy comprised of savers, and not wholly reliant on over-leveraged consumers. We need a Fed that sees the risks of year after year of zero interest rates wherein investors must hunt for yield in asset classes to which they are not suited. We need a Fed that does not empower runaway spending by the federal government. And most importantly, we must demand a Fed that serves as a utility institution in our economy, not an enabler of some perverse financial system addiction.
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The writer is a Republican US senator from Tennessee and member of the Senate banking committee



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Copyright The Financial Times Limited 2012.