President Trump’s nominee to be Federal Reserve chairman, Jerome Powell, is expected to continue the Fed’s restrained approach to reversing the central bank’s crisis-era stimulus policies. This would mean gradually raising short-term interest rates and slowly shrinking the Fed’s $4.5 trillion portfolio of Treasury bonds and mortgage-backed securities.
Powell, a Fed governor since 2012, consistently voted with Chairwoman Janet Yellen and shared her concerns that inflation might remain low for a long time. The Fed in recent years has been more concerned with prices dropping (deflation) than with price increases (inflation). A low inflation rate would encourage consumers to delay purchases and businesses to postpone investments. This cause gross national product to fall.
Our low inflation numbers reflect not only transitory factors such as hurricanes and cold weather but also long-run developments. Long-run factors such as technological improvements and globalization have lowered prices below the 2 percent annual growth rate that has been the Fed’s target for a healthy economy.
Yellen said following the Fed’s September meeting, said that economy was strong but “low inflation, even with higher energy prices and a weaker dollar, is more of a mystery.”
Why worry about inflation being too low?
As David Wessel of the Brookings Institute pointed out, every price you pay is someone else’s income. When Fed officials express concerns about low inflation, they are indirectly reflecting their concern that incomes and wages have not risen enough. Over the past few years, wages have risen around 2.5 percent.
What causes prices to rise and fall? The main factors are supply and demand. The Arab embargo in 1973 causing a quadrupling of oil prices is one extreme example.
While low inflation is bad, long-term increases in inflation also have far-reaching economic effects. Such rises generally lead to higher wages and higher personal income, which then causes companies to raise prices as a consequence of their higher costs.
As a consequence of the high inflation in the 1970s, Congress made the Federal Reserve responsible for managing inflation. The Federal Reserve Act of 1977 requires the Fed to “promote effectively the goals of maximum employment, stable prices and moderate long-term rates.”
The Fed’s dual mandate requires it to balance the strength of the labor market against the risk that employment growth might lead to wage-driven inflation.
During the financial crisis of 2008, the Fed introduced a new policy called quantitative easing to prevent a depression. Under QE, the Fed bought up Treasury bonds and mortgage-backed securities in an attempt to boost bank reserves, allowing more business expansion, home purchases and other types of consumption. QE expanded the Fed’s balance sheet five-fold, from about $900 billion in the summer of 2008 to its current level of $4.5 trillion.
Critics of the Fed’s QE worry that it has caused an asset bubble. The S&P 500 and Nasdaq stock indexes have recently reached all-time closing records. The Dow Jones Industrial Average has set 70 new record closing highs since the 2016 presidential election.
To prevent inflation — one of the leading causes of an economic recession — the Fed might need to raise interest rates faster than currently anticipated.
On the other hand, an inflation rate below 2 percent can force the Fed to lower its benchmark interest rates, which already are at historic lows despite recent incremental increases. Such low rates reduce the ability of central banks to respond with corrective action. While some European central banks have introduced negative rates to combat deflation, our Fed was content to leave them at zero.
It’s a tightrope over a chasm. We wish Chairman Powell good luck in seeing our economy safely across.
Originally published in the Sarasota Herald-Tribune
