Ben Bernanke has an inflation problem. There isn't any inflation and that's a problem.
In the last 12 months, consumer prices have risen a mere 1.1 percent which -- according to Bloomberg -- "matches the smallest increase since records began in 1960." At the same time, the velocity of money (how fast money changes hands) has slowed to a crawl, in fact, it's slower than anytime since 1959. Naturally, this lethal combo (low inflation-slow velocity) has impacted growth which just clocked in at a pitiable 1.8 percent. If present trends continue, disinflation could turn to outright deflation sometime in the latter half of 2014, leading to further economic deceleration.
But why is low inflation a problem, after all, lower prices mean consumers get more bang for their buck, right? How can that be bad?
It's bad because low inflation is a sign of stagnation. When demand is weak, there's little upward pressure on prices. In a deflationary environment, people hold onto their cash figuring that prices will be lower in the future. Hoarding, in turn, leads to reduced borrowing and spending which puts the economy into a nosedive. It's all bad. That's why the Fed has a 2 percent inflation target that it tries to maintain by pumping money into the financial system; it's to incentivize spending by creating inflation.
So why has the Fed failed to hit its inflation target when it's expanded its balance sheet by more than $2.3 trillion since Quantitative Easing (QE) first began? Hasn't all that bond buying pushed up prices?
Nope, it hasn't, and it's easy to see why. When the Fed creates reserves at the banks (QE) it adds to base money, but that money does not trickle down to the real economy until the worker bees (you and me) take out loans or run up our VISAs. When credit is not expanding (which it isn't except for student loans and subprime auto loans), activity flags and the economy shifts into low gear. That's where we are now.
The Fed can change this dynamic by boosting "inflation expectations," which is to say that if people believe the Fed will succeed in raising inflation, then they'll spend more dough than they would have otherwise. But Bernanke has flopped on that account, too. His recent announcement (that he would scale back on his asset purchases if the economy improved) sent markets plunging, but even worse, it drove a dagger into inflation expectations. Now no one believes the Fed can raise inflation via QE. The damage to the Fed's credibility is incalculable.
Paul Krugman thinks Bernanke made a "historic mistake" by talking about tapering too soon, but Krugman also thinks he knows how to minimize the fallout. All Bernanke needs to do is convince the markets that he's crazy. Here's a clip from Krugman's blog at the New York Times:
"What's the point of Fed communication? Mainly it's not about the specific numbers; it's about conveying what kind of central bankers we're dealing with, and hence what they're likely to do in the future. Talk of extended easy money can help the economy now precisely because it makes the Fed sound like it's not a conventionally-minded central bank, eager to snatch away the punch bowl; even asset purchases work mainly because they reinforce that impression of unconventionality."
This post is a follow-up from an earlier piece in which Krugman said the Fed must "credibly promise to be irresponsible". In other words, Bernanke needs to convince everyone that he's seriously lost it and is going to keep his foot on the gas long after the economy has rebounded. That will send consumers racing off to the shopping malls to buy more trinkets before prices rise.
Are you convinced yet?
Of course, there are a few glitches to this theory, like the fact that higher inflation expectations can't boost spending when people are already broke. Broke is broke. It's a condition that people experience in an economy where unemployment is high and wages are stagnant or falling. The cost of money (interest rates) doesn't matter to people who are broke because they're not taking out a loan anyway so they don't give a rip. To them, higher inflation just means more cutbacks at the grocery store or shopping center. This is what we're seeing in Japan, where the Bank of Japan (BoJ) is on track to double the money supply in the next two years but prices are still falling and the economy is still in the grip of deflation. Take a look at this from Reuters:
"Core consumer prices continued to fall and manufacturers forecast further weakness ahead, government data showed on Friday, underscoring the challenges the Bank of Japan, under new Governor Haruhiko Kuroda, faces in meeting its 2-percent inflation target.
"'The deflationary trend shows no signs of changing,' said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance in Tokyo.
"'Expectations for deflation, deeply embedded among the public, are very persistent,' Kodama said. 'It appears quite difficult for monetary easing implemented by Governor Kuroda to achieve a positive cycle of inflation and economic recovery.'"