Ben Bernanke’s Nightmare in a Stack of Boxes
By Caroline Baum
NEW YORK – Ben Bernanke arrived at his office a week ago and came face to face with his worst nightmare.
Staring out at the Federal Reserve chairman from page C1 of the Feb. 3 edition of the Wall Street Journal was a photo of a man and his boxes. The man was John Anton, president of Anton Sports. The boxes contained his inventory of T-shirts. Because the price was right, Anton borrowed $300,000 at 2.45 percent to lay in a year’s supply — 2,500 boxes, compared with a more normal 30 — in anticipation of higher cotton prices.
And why not? He has seen the future, and the future is higher prices. When commodity prices are rising faster than the cost of financing inventory, businesses have every incentive to stockpile, even if they don’t expect a pick-up in sales. It’s profit-maximization, pure and simple.
Is this what the Fed had in mind when it floated the idea last year of raising inflation expectations to lower real interest rates to get America spending again? I doubt it. But it’s the natural outgrowth of all its efforts.
Take QE2, for example, the Fed’s second foray into quantitative easing via the purchase of $600 billion of Treasuries from November through June. To the extent that the goal of QE2, as outlined by Bernanke, was to drive down Treasury yields and drive up the prices of other financial assets to make consumers feel wealthier, there is reason for concern.
It wasn’t long ago that double-digit annual increases in home prices made consumers feel wealthier. They borrowed and spent until that wealth evaporated.
The Fed seems to have succeeded, and maybe too well, in thwarting deflationary psychology, thanks to some help from overly easy monetary policy in some developing countries and booming commodity prices.
Which brings us back to Anton. He isn’t hoarding T-shirts because he expects the consumer price index to rise, say, 3 percent next year. He’s hoarding T-shirts because he expects cotton prices, which jumped 137 percent in the past year, to increase further.
“Everyone faces a different expected inflation depending on what he does for a living,” says Neal Soss, chief economist at Credit Suisse in New York. “That’s one of the real weaknesses of the expected inflation/real rate story.”
Don’t tell Fed policy makers. Their models determined that raising inflation expectations would lower the real interest rate, making it less attractive to hold cash and increasing the incentive for consumers to spend. Their models never envisioned a rise in nominal rates.
The yield on the 10-year Treasury note shot up to a 10- month high of 3.74 percent earlier this week from 2.4 percent in October. Most of that increase has been in the real rate, which the Fed now says reflects increased optimism about the economy.
Anton, of course, is an anecdote. Somewhere out there, just waiting for a journalist to knock on his door, is his counterpart, whose experience with prices is confined to those that are falling.
It just so happens Anton illustrates a dominant theme, which is rising global commodity prices, food riots in less developed countries where a large share of income is spent on necessities, and fears that the Fed missed the boat on QE2 (sorry).
Forget the frequent references to “food inflation,” “commodity inflation” or, even worse, “cost inflation.” These are all misnomers. Yes, food prices are rising, as are commodity prices. They aren’t inflationary per se unless the Fed allows those relative price increases to translate into a generalized rise in all prices.
The best way to ensure that happens is to keep interest rates at zero, creating an incentive to borrow at a low rate to finance something that’s appreciating in price.
To date, there’s no sign of a borrowing binge. Commercial and industrial loans, which companies use to finance inventories, have inched up in the last two months after a two – year decline. And the amount of credit-card debt outstanding posted its first increase in December after 27 monthly declines. Still, bank credit, which posted back-to-back increases in July and August, is contracting again, according to Fed data.
At a Wednesday hearing of the House Budget Committee, Bernanke reiterated that the Fed has both means and motive to pare its $2.47 trillion balance sheet and raise the benchmark rate to avert an unwanted increase in inflation “at the appropriate time.”
The last time the Fed was prescient, and preemptive, was 1994, so I wouldn’t count on it. Let’s hope they start down the Road to Normal before they find out we’re all John Antons now.
Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist.
Remember why inflation expectations matter
By Paul Segal
Macroeconomists have understood for a long time that inflation expectations are an important determinant of inflation. But those who argue that interest rates must be raised today in order to keep inflation expectations down have forgotten why these expectations matter in the first place.
The idea that governments can systematically stimulate the economy at the cost of high, but stable, inflation went bust during the stagflation of the 1970s. The reason is that high inflation over time leads to high expected inflation, and that these expectations will themselves then tend to raise inflation in the future as wage bargaining and other contracts take expected inflation into account. The result is not high and stable inflation, but rather high and ever-increasing inflation – – an unsustainable situation.
Hawkish discussions of inflation expectations today, and their potential effects on actual inflation in the future, remember the conclusion but seem to have forgotten the argument. Expectations of high future inflation lead to high actual inflation in the future only if workers and firms are able to pass that expected price rise through to their own contracts. If inflation is expected to be 4 per cent this year and this is expected to lead to a 4 per cent rise in nominal profits, then unions will reasonably demand a 4 per cent pay rise as a baseline, to avoid a fall in real wages. If firms then raise prices further in response to the higher wages then a wage-price spiral will result.
But today, high inflation is due not to a general rise in all nominal prices. It is driven primarily by the continuing effects of sterling’s devaluation, rising commodity prices, and rising VAT. So the recently-reported 3.7 per cent rate of UK inflation does not reflect a comparable rise in nominal profits. It implies a squeeze on both real profits and real wages because it reflects a deterioration in the UK’s terms of trade: imports have got more expensive relative to exports, so the country as a whole, both its firms and workers, are correspondingly poorer.
Since profits have not risen with inflation, workers cannot demand a 3.7 per cent rise in wages without driving their already-struggling employers towards bankruptcy. Moreover, with high unemployment, workers are in a poor bargaining position. If they try to demand wage rises there are plenty of unemployed workers willing to work at lower wages. They may not want a real pay cut, but they may have no choice. Similarly, firms cannot raise their prices enough to maintain profits in the face of more expensive imported inputs because of low demand in the economy. They too have to take the hit through lower real profits.
In this context it is just not valid to argue that interest rates must be raised now in order to keep inflation expectations down, in order to keep actual future inflation down. Both steps are mistaken.
First, news of high recent inflation should not lead to higher inflation expectations, because the economic context strongly militates against any pass-through of this inflation to wages and other long-run contracts.
Second, let’s suppose expectations of future inflation are high anyway. For instance, if you think that commodity prices will continue to rise then you may think that this will cause inflation to stay high. But for the same reason, this expectation of high inflation cannot itself cause even higher actual inflation in such economically-straitened times. Again, workers and firms know they have to take the hit, and cannot push for higher wages or prices to compensate.
Inflation may remain above target. But fear of inflation expectations has become an article of faith divorced from the economic mechanisms that, in more normal times, make them matter. As long as the economy remains well below capacity, with unemployment high, and with wages lagging behind inflation, raising interest rates can only make a bad situation worse.
Paul Segal is lecturer in economics at the University of Sussex