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Should the Fed Be Concerned about Low Price Inflation?

Economics / Inflation Oct 26, 2010 - 10:44 AM GMT

By: Frank_Shostak

Economics

Best Financial Markets Analysis ArticleIn its September 21 meeting, the Federal Reserve Open Market Committee expressed concern that the rate of inflation is far too low. According to the minutes some members of the FOMC have said,


that unless the pace of economic recovery strengthened or underlying inflation moved back toward a level consistent with the Committee's mandate, they would consider it appropriate to take action soon. With respect to the statement to be released following the meeting, members agreed that it was appropriate to adjust the statement to make it clear that underlying inflation had been running below levels that the Committee judged to be consistent with its mandate for maximum employment and price stability, in part to help anchor inflation expectations. … The Committee was prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

Meanwhile, on Friday, October 15, Federal Reserve chairman Ben Bernanke hinted that the US central bank is ready to push more money into the economy in order to reverse the present slide in the growth momentum of the consumer price index. He said that the low level of inflation presented a risk of deflation. "There would appear, all else being equal, to be a case for further action," Bernanke said at a conference sponsored by the Boston Federal Reserve Bank.

The yearly rate of growth of the consumer price index (CPI) stood at 1.1 percent in September against 1.1 percent in the month before and 2.6 percent in January. The yearly rate of growth of the CPI less food and energy — the core CPI — stood at 0.8 percent last month versus 0.9 percent in August and 1.6 percent in January — well below the 2 percent level of the unofficial Fed target, which is considered to be consistent with price stability.

The popular way of thinking maintains that a policy of price stability doesn't always imply that the central bank must fight inflation. It is also the role of the central bank to prevent large falls in the rate of inflation, or an outright decline in the general price level. Why is that so? Because it is held that a fall in the price level, labeled price deflation, postpones consumer and business expenditure and thereby paralyzes economic activity.

Moreover, a fall in price inflation raises real interest rates and thereby further weakens the economy. Additionally, as expenditure weakens, this further raises unutilized capacity and puts further downward pressure on the price level. Most economists are of the view that it is much harder for the central bank to handle deflation than inflation. When inflation rises it is argued the central bank has no limit as such on how much it can raise interest rates to "cool off" the economy. This is, however, not so with regard to deflation. The lowest level that the central bank can go to is a zero interest-rate level.

For instance, let us assume that Fed policy makers have reached the conclusion that, in order to revive the economy, real interest rates must be lowered to a negative figure. This, however, may not always be possible to accomplish, so the argument goes.

When nominal or market interest rates are at a zero level it is not possible to make real interest rates negative when the price level is falling. Here is why.

From the popular definition that

nominal interest rate = real interest rate + percent change in price level,

it follows that

real interest rate = nominal interest rate − percent change in price level.

Hence, when nominal interest rate is 0 and the price level falls by 1 percent,

real interest rate = 0 + 1 percent.

As the pace of deflation intensifies, the increase in real interest rates also intensifies. In this situation the Fed's interest-rate weapon becomes ineffective. For instance, in order to lower real interest to −0.5 percent the central bank would need to lower nominal interest rates to −1.5 percent (real interest rate = −1.5 percent + 1 percent = −0.5 percent). Obviously, this cannot be done, because no one would lend in return for a negative nominal interest rate — people would rather hold the money, so it is argued.

Likewise, when the rate of inflation is very low it can also create problems. Suppose that on account of weak aggregate demand, inflation has fallen from 2 percent to 1 percent. Within this setup the central bank can only target a real interest rate of −1 percent. It cannot aim at a lower real interest rate since this would imply setting nominal interest rate below zero (−1 percent = 0 percent − 1 percent). In order to target for real interest rate of −1.5 percent nominal rate must fall to −0.5 percent (−1.5 percent = −0.5 percent − 1 percent).

Similarly as the economy weakens further and inflation falls to 0.5 percent this will not allow the central bank to target real interest rates to below −0.5 percent. In short, deflation, or low inflation, reduces a central bank's flexibility in reviving the economy.

Hence, it is argued, the policy of price stability must aim at a certain level of inflation that will give the central bank the flexibility to keep the economy on the growth path of economic prosperity.

So what should this level of inflation be? Some experts are of the view that 2 percent to 3 percent is the best range. (Fed officials are of the view that 2 percent is the right figure.) The essence of all this is that a little bit of inflation is a must in order to have economic prosperity and stability.

According to this way of thinking the inflationary buffer must be big enough to enable the Fed to maneuver the economy away from the danger of deflation, or so it is held.

As a rule a general increase in prices comes on account of the increase in money "out of thin air." An increase in money out of thin air leads to an exchange of nothing for something, or to the economic impoverishment of wealth generators. So how in the world can price inflation of 2 percent to 3 percent, which is called buffer inflation, promote economic growth and prosperity? It is absurd to regard a price inflation of 2 percent as some kind of optimum.

Contrary to popular thinking, it is not a fall in prices as such that weakens real economic growth but the declining pool of real savings. (The declining pool weakens the process of real-wealth generation.)

Now the conventional thinking is of the view that individuals will not lend at negative nominal interest rate. For some strange reason mainstream thinkers hold that the Fed could target negative real interest rates and individuals will be happy to lend at these rates. We suggest that mainstream thinkers have reached this erroneous conclusion as a result of a misleading view regarding what the real interest rate is all about.

The real interest rate is not the difference between the nominal rate and the change in the CPI; it is actually the rate of exchange between present goods and future goods. Also, there is no such thing as the real interest rate — there are a multitude of real rates, which cannot be added to a total.

Since monetary pumping undermines the formation of capital and weakens economic growth, it actually leads to a higher rate of exchange between present to future goods. (As people get poorer, the importance they assign to present goods increases — the real interest rate increases.)

A so-called lowering of "real" interest rates by means of money pumping is basically an act of a diversion of real wealth from wealth generators to various nonproductive activities. Hence, contrary to popular thinking, the Fed's attempt to lower the real interest rate in fact leads to a higher real interest rate. (The Fed does not have control over people's time preferences.)

It is a fallacy to hold that an increase in the pace of inflation will revive the economy. If the pool of real savings is falling, then even if the Fed were to be successful in dramatically increasing the price level the economy would follow the declining pool of real savings. In this situation the more money the Fed pushes to the economy the worse the economic conditions become. Again, pumping more money only weakens the wealth-generating process.

Conclusion

In its September 21 meeting Fed officials expressed concern that the US rate of inflation is far too low. Also, on Friday the Fed chairman hinted that the US central bank is ready to push more money to reverse the slide in the growth momentum of the CPI in order to revive the economy. We suggest that if the pool of real savings is declining then, even if the Fed were to be successful in dramatically increasing the price level, the economy will follow the declining pool of real savings. In this situation, the more money the Fed pushes the worse the economic conditions become.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail. See Frank Shostak's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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