St. Louis Federal Reserve President James Bullard is making some headlines today. He fears that inflation expectations are becoming unglued:
Is this happening? Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target.
He seeks to prove this claim with this chart:
I just can't let this one go. I honestly don't know if I should laugh or cry. I have a whole new respect for Federal Reserve Chairman Ben Bernanke if this is any indication of the kind of grief he needs to deal with on a regular basis.
This is disingenuous on two levels. The first is that TIPS returns are based on CPI inflation, not the Fed's PCE inflation target. I find it hard to believe that Bullard does not understand the distinction. Putting the Fed's inflation target on this chart is comparing apples to oranges. Bullard should know this. If he does, he is deliberately misleading his audience. If he doesn't...well, I don't really know what to say about a top monetary policymaker that can't identify the proper inflation target.
To understand why the TIPS breakeven rate will be above the Fed's PCE inflation target, simply note that CPI inflation tends to run above PCE inflation, on the average of about 44bp since 1990:
The second reason this is disingenuous is the length of the time series. Bullard begins his chart at the beginning of this year, leaving the audience to believe that these high inflation expectations are a new phenomenon. Again, deliberating misleading the audience. Let's go to the tape:
Nothing to see here, folks. Move along.
Bullard starts down this path as a response to suggestions for higher inflation to reduce real debt burdens. This appears at least partly in response to his realization that the work of Professors Reinhart and Rogoff is not as obviously supportive of his position as he previously believed. Rogoff has offered up the possibility of higher inflation to address the debt load. Bullard offers a number of bullet points in response:
The partial default would occur against savers, mostly older U.S. households, and against foreign creditors.
Alas, in economics there is no free lunch.
A partial default today through higher inflation would be paid for via higher inflation premiums in future borrowing.
There is an important point here - a partial default will have winners and losers. But guess what? So will no default, hard or soft. Just ask the people of Greece (worst of all worlds, partial hard default). Or Ireland. Or Spain. As I said with regard to the Japanese situation:
They are all taxpayers and bondholders. They take the hit in taxes, spending, or capital position. The longer they wait to take that hit, the bigger it will be....
...In other words, you can take your inflation medicine a little bit at a time, or a whole bunch at once. But a even a little bit at a time becomes increasingly more difficult politically as the debt load grows larger.
Pay attention to the last line; Bullard is already identifying older households as a class resistant to taking a capital loss. But they are also struggling with low returns. Now they can't win. This is exactly the trap Japan found itself in - those who initially lost from the zero bound lose again if they were to exit the zero bound. The zero bound is a very bad place to be for an extended time. I don't think the Federal Reserve takes this problem seriously enough.
In short, Bullard wants to pretend that the only costless option is the strict low inflation option. That's simply not true. It has a cost as well, in a particular distribution of winners and losers. A higher inflation target will result in a different distribution of winners and losers that may be more beneficial to domestic residents if, for example, the burden of higher inflation were to fall disproportionately on foreign central banks who have acquired large holdings of dollar assets for mercantilistic reasons (hint, hint). There is also the issue of using inflation to lower the real rate at the zero bound.
It very well may be the case that the US economy normalizes such that output returns to a level that the fiscal impulse can be lessened and debt to GDP ratios level off and decline while interest rates climb such that the Fed returns to using the fed funds rate as their primary tool throughout the next cycle. In such a scenario, there may be no need to exercise the inflation option. But other equilibriums are possible. Japan never experienced sufficient lift-off to break its reliance on fiscal stimulus. Policymakers should be aware of the possibility and adopt a flexible response, one that does not a priori rule out what may be the most cost-effective options.
Bottom Line: If Bullard wants to take a hard line against higher inflation, so be it. In reality, that hard line has been adopted by the vast majority of Fed officials. They aren't inclined to touch the inflation option for fear, I think, that it would work. Then what's to stop 4% from becoming 6%? And 6% from becoming 8%? And I do believe this question would need to be addressed. But don't pretend that not pursuing the inflation option is costless. Just different costs. And please don't use an obviously disingenuous data analysis to fuel inflation fears. We expect better from our policymakers. Or at least we should.
