As Senate Weighs Yellen for Fed, Fed Weighs Inflation

Somewhere between Venezuela and Japan is exactly the right spot, when it comes to inflation. Getting the United States there could be a key challenge for Janet Yellen.

The country’s central bank right now wants a little more inflation than the current rate of 1.2 percent, lest it sink backward into the kind of deflation that can sap an economy, as it has in Japan. At the same time, some economists worry that the Fed’s stimulus of the economy now will have an inflation hangover later, driving an excessive rate of jumping prices, such as those that hurt the United States in the late 1970s and early 1980s, and wrack a country such as Venezuela today.

Yellen, nominated by President Barack Obama to be the new chair of the Federal Reserve, will wrestle with the right approach, if confirmed by the Senate.

The tension between the Fed sparking some inflation and the risk of losing control of it spilled into the Senate Banking Committee on Thursday, as it opened hearings into Yellen’s nomination. Inflation, she said Thursday, “has been running below the Federal Reserve’s goal of two percent, and is expected to continue to do so for some time.”

All but forgotten for most Americans, inflation erodes their spending power. It’s particularly hard on retirees who are living on a fixed income that does not grow as fast as paychecks, and not nearly fast enough to keep pace with prices. Once in the double digits a generation ago, the inflation rate has been below the Fed’s target rate of two percent for much of the economic recovery that began in June 2009. It’s gone from 2.2 percent in October 2012 to 1.2 percent this September.

“I see the inflation risk as a remote one, and the deflation risk as potentially greater,” said John Makin, a resident scholar at the center-right American Enterprise Institute.

With rising inflation, consumers and businesses buy on fear that prices will rise further. This is happening today in Venezuela, where an unofficial inflation rate of 50 percent has crowds rushing to buy some types of electronics before prices jump. This surge in demand makes products scarce, and thus even more expensive.

Deflation, experienced by Japan over the past decade, is when consumers and businesses sit on the sidelines. in a collective bet that they’ll get a better price later. Retailers must cut prices on those electronics, or even sell them at a loss. Multiplied across the economy, the effect is devastating.

Combating deflation by creating inflation is implicit in the Fed’s controversial monthly purchase of government and mortgage bonds. Since December 2012, the Fed has been buying $85 billion of these bonds every month, with the express intent of  driving down the cost of long-term loans for consumers and businesses. It’s made it easier to buy a car, and cheaper to buy a house. It’s raised the price of stocks, boosting fortunes on Wall Street and the investment and retirement savings of ordinary Americans alike.

All that activity has helped spur some inflation, by fostering more economic activity and making people feel wealthier and willing to spend.

In the process, the Fed’s effectively created money to purchase government and mortgage bonds, pushing its holdings to $3.8 trillion.

Historically, when a government prints more money, it reduces the value of that money. That causes prices to rise – inflation – because producers need to get more for their product, since what they’re earning now buys less.

And it becomes a vicious circle. It’s why some critics warn that inflation’s being baked into the unconventional economic stimulus.

“If you keep pumping money into the economy, and that money starts to find its way into [sales] … it’s in the pipeline,” said Martin Regalia, chief economist for the U.S. Chamber of Commerce. “If it does start to increase the money supply . . . it absolutely will create inflation. And at that point, the horse is out of the barn.”

In this case, the money has not gone directly into the economy as increased money supply.

Supporters of the Fed policy scoff at the idea of looming excess inflation.

“I don’t think there is any sign of inflation just over the horizon,” said Donald Kohn, who preceded Yellen as the Fed vice chairman. “Some people wonder how long it will take to get the inflation rate up to the two percent target, rather than over it.”

Kohn points to the high unemployment rate and the large number of people who have exited the labor force. He suggests that there is so much slack in the economy that it’d be hard for inflation to take root in the next several years.

“There is very little pressure on wages, unit labor costs . . . I don’t think there is any real evidence that inflation is around,” said Kohn, now a senior fellow at the center-left Brookings Institution think tank. “It’s very hard for inflation to get going. I don’t care how big the Fed’s balance sheet is.”

The question of who is right on this issue matters. Excess inflation creates challenges, because the Fed raises interest rates when inflation rises, slowing the economy and making it more costly for the government to borrow to pay its debts. Government cost-of-living adjustments are indexed to inflation, meaning the government will need to pay Social Security recipients more, to compensate for their eroding spending power.

For now, inflation appears subdued, deflation seems the bigger threat and most economists root for a little more of what normally would be a bad thing.

“I think we’re going to start having more inflation next year, and so what? It’s actually a good thing,” said James Paulsen, chief investment strategist for Wells Capital Management in Minneapolis. “The question is, does it get out of control? I wouldn’t give it 50 percent odds. I would put the odds more at one in four, or one in three.”