Janet Yellen on Inflation

From a recent speech:

Let me now turn to an issue that has lately garnered a great deal of attention—inflation. Just a short time ago, most economists were casting a wary eye on the risk of deflation—that is that prices might drop, perhaps falling into a downward spiral that would squeeze the life out of the economy. Now, though, all I hear about is the danger of an outbreak of high inflation.

I’ll put my cards on the table right away. I think the predominant risk is that inflation will be too low, not too high, over the next several years. I take 2 percent as a reasonable benchmark for the rate of inflation that is most compatible with the Fed’s dual mandate of price stability and maximum employment. This is also the figure that a majority of FOMC members cited as their long-run forecast for inflation, according to the minutes of the committee’s April meeting.

First of all, this very weak economy is, if anything, putting downward pressure on wages and prices. We have already seen a noticeable slowdown in wage growth and reports of wage cuts have become increasingly prevalent—a sign of the sacrifices that some workers are making to keep their employers afloat and preserve their jobs. Businesses are also cutting prices and profit margins to boost sales. Core inflation—a measure that excludes volatile food and energy prices—has drifted down below 2 percent. With unemployment already substantial and likely to rise further, the downward pressure on wages and prices should continue and could intensify. For these reasons, I expect core inflation will dip to about 1 percent over the next year and remain below 2 percent for several years.

If the economy fails to recover soon, it is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more. But I don’t view this as likely. The vigorous policy actions of the Fed and other central banks, combined with sizable fiscal stimulus here and abroad, have sent a clear message that deflation won’t be tolerated. Based on measures of inflation expectations, the public appears confident that the Fed will adopt policies that will maintain a low, positive rate of inflation. Evidently, the credibility that the Fed and other central banks have built over the past few decades in bringing inflation down has spilled over into a belief that we won’t allow inflation to get too low either. This does not mean that a short episode of deflation couldn’t occur, but it makes a prolonged and devastating deflationary spiral less likely.

None of what I just said will satisfy those who worry about inflation. Indeed, if you listen to popular business news channels, you might hear a drumbeat of concern that the Fed could let inflation get too high. Those who hold this view point to the rise in Treasury yields and commodity prices this year as signs that runaway inflation is on the horizon. They muster three arguments. The first is that the Fed has pumped up the money supply and expanded its balance sheet to fund its financial rescue programs, potentially igniting inflation. The second is that the Fed runs the risk of repeating the errors of the 1970s by focusing on mistaken views of economic slack rather than rising prices. The third is that large fiscal budget deficits will create higher inflation. I take all of these concerns very seriously and will address each in turn.

First, I’ll talk about the Fed’s balance sheet. As I discussed earlier, the Fed has taken a number of strong steps to avert a financial and economic meltdown, and to support the flow of credit. These policies have caused the assets on the Fed’s balance sheet to more than double, from under $900 billion at the start of the recession to over $2 trillion now. This expansion is largely financed by increases in bank reserves, that is, surplus cash that banks deposit with us. Some worry that the Fed’s balance sheet expansion is pumping money into the economy and will be inflationary. But, as I will explain in a moment, we have the tools needed to tighten policy and head off future inflation. There is also some concern that the Fed could be trapped by conflicting goals if, at some point, a growing economy requires a higher federal funds rate, before credit markets are fully healed. Finally, some worry that the Fed may lack the political will to tighten policy when the time comes.

I will be the first to say that it is always difficult to get monetary policy just right. But the Fed’s analytical prowess is top-notch and our forecasting record is second to none. The FOMC is committed to price stability and has a solid track record in achieving it. With respect to our tool kit, we certainly have the means to unwind the stimulus when the time is right. Many of the special programs we developed to provide emergency credit to the financial system are already tapering off as market conditions improve. Many of the assets that we have accumulated during the crisis, such as Treasury and mortgage-backed agency securities, have ready markets. And the Fed can push up the federal funds rate by raising the rate of interest that we pay to banks on the reserve balances they have on deposit with us—authority that was granted to us by Congress last year. An increase in the interest rate on reserves will induce banks to lend money to us rather than to other banks and borrowers, thereby pushing up the federal funds rate and other rates charged to private borrowers throughout the economy. The ability to pay interest on reserves is an important tool because, as I mentioned, it’s conceivable that, even if the economy rebounds nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. This tool will enable us to tighten credit conditions even though our balance sheet wouldn’t shrink.

Let me turn to the second concern, that we could have a rerun of the stagflation of the 1970s. Some economists have argued that the Fed misjudged how low the unemployment rate could go without igniting inflation and, as a result, lowered the federal funds rate too far for too long, an overly accommodative stance that contributed to runaway prices. 6 This is an issue we have studied in great depth, looking at a wide range of data sources and using a variety of techniques to estimate slack in labor and product markets. Not surprisingly, these estimates vary. But they all plainly show that labor and product markets are currently operating well below the levels that would trigger inflation. We must beware of overconfidence that we have too precise a handle on these questions. But, to me, the evidence is clear that the economy has substantial slack and we are far from the kinds of unemployment rates that would make inflation a danger.

The third concern is that big federal budget deficits might eventually be inflationary. In my years of teaching at Berkeley, I regularly lectured on the relationship between fiscal deficits and inflation. A glance at history shows that many countries with massive structural deficits and without an independent central bank turned to the printing press to pay off their debts. That’s a recipe for high inflation and, in some cases, hyperinflation.

But I don’t believe the United States faces that threat. Looking back in history, runaway fiscal deficits have often been accompanied by high inflation. 7 But, since World War II, such a relationship has only held in developing countries. 8 In countries with advanced financial systems and histories of low inflation, no such connection is found.