Bernanke Makes the Case for Low Inflation for A Very Long Time To Come

On Friday, Federal Reserve Chairman Ben Bernanke spoke at a conference on “Revisiting Monetary Policy in a Low-Inflation Environment” in Boston with a speech titled “Monetary Policy Objectives and Tools in a Low-Inflation Environment.” He provided some very insightful commentary regarding the Fed’s treatment of de/inflation risks.

First, no surprise, the Fed believes the outlook for inflation is very tame:

“Generally speaking, measures of underlying inflation have been trending downward. For example, so-called core PCE price inflation (which is based on the broad-based price index for personal consumption expenditures and excludes the volatile food and energy components of the overall index) has declined from approximately 2.5 percent at an annual rate in the early stages of the recession to an annual rate of about 1.1 percent over the first eight months of this year. The overall PCE price inflation rate, which includes food and energy prices, has been highly volatile in the past few years, in large part because of sharp fluctuations in oil prices. However, so far this year the overall inflation rate has been about the same as the core inflation rate.

The significant moderation in price increases has been widespread across many categories of spending, as is evident from various measures that exclude the most extreme price movements in each period. For example, the so-called trimmed mean consumer price index (CPI) has risen by only 0.9 percent over the past 12 months, and a related measure, the median CPI, has increased by only 0.5 percent over the same period.”

Moreover, the forecast for inflation remains below the Fed’s 2% target. Such a condition mandates action, but the Fed finds itself constrained with rates already at zero percent:

“The longer-run inflation projections…indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve’s dual mandate in the longer run. In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable. Given that monetary policy works with a lag, the more relevant question is whether this situation is forecast to continue. In light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation–setting aside the inevitable short-run volatility–will be less than the mandate-consistent inflation rate for some time.”

Notably, Bernanke did NOT directly mention the soaring costs of food and commodities, especially gold and silver, in his remarks. He did not consider whether further anti-deflationary action by the Fed will cause additional price disruptions and pressures outside the borders of the U.S. Instead, Bernanke focused on generalized and aggregate inflation expectations in the U.S.:

“The public’s expectations for inflation also importantly influence inflation dynamics. Indicators of longer-term inflation expectations have generally been stable in the wake of the financial crisis. For example, in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters, the median projection for the annual average inflation rate for personal consumption expenditures over the next 10 years has remained close to 2 percent. Surveys of households likewise show that longer-term inflation expectations have been relatively stable.”

Debate has raged over whether TIPS are indicating a pick-up in inflation expectations. Bernanke now weighs in, stating that TIPS are well within historical norms:

“In the financial markets, measures of inflation compensation at longer horizons (computed from the spread between yields on nominal and inflation-indexed Treasury securities) have moved down, on net, this year but remain within their historical ranges.”

Net-net, Bernanke concludes that all’s quiet on the inflation front: “With long-run inflation expectations stable and with substantial resource slack continuing to restrain cost pressures, it seems likely that inflation trends will remain subdued for some time.” And thus the Fed worries about the risks of deflation. So much so, that now Bernanke is toying with changes to the statement of monetary policy to indicate “…the Committee expects to keep the target for the federal funds rate low for longer than markets expect.”

Sounds like the Federal Reserve is getting ready to dig in its heels. Stay tuned!