The credibles

July 19, 2011

Is Federal Reserve Chairman Ben Bernanke the Paul Volcker of falling prices?

Just as Volcker cemented the Fed’s inflation-fighting credibility by knocking soaring prices back to earth with recession-causing rate hikes, Bernanke may be carving out a similar niche in thwarting the other dark side of price stability: combating the threat of a deflationary spiral.

In a research note, JPMorgan economist Michael Feroli wonders why inflation has stabilized at low levels despite high unemployment and slow growth. His conclusion: the Fed’s aggressive measures to beat back the recession and support the weak recovery have led markets to be confident the Fed will not allow a deflationary psychology to take hold.

Inflation has ticked higher recently, but is expected to moderate as energy costs and car prices come down.

But for inflation to stabilize with unemployment so high and much factory capacity still idle is at odds with economists’ models, even ones that are adjusted for inflationary psychology, Feroli says. These models would predict that inflation should be falling into deflationary territory.

What is going on? Perhaps the natural rate of unemployment is higher than the 5 percent to 6 percent Fed economists peg it at, putting less downward pressure on inflation. Or perhaps there is something about low levels of inflation that makes them less likely to respond to a large amount of slack in the economy.

But Feroli rejects both arguments. For one, the idea that that there are jobs, but not enough qualified workers to fill them — which might point to a higher natural unemployment rate — doesn’t hold up because data show that in most occupations, higher unemployment rates exist than before the downturn.

In any case, even if the natural unemployment rate were higher, the gap between, say, 7 percent and 9 percent is still wide enough to dictate downward pressure on inflation, he says. Similarly, it is unlikely that inflation is somehow less responsive to slack just because price rises are muted, Feroli says. Businesses tend to be able to adjust prices and labor costs downward pretty easily, potentially allowing lots of scope for deflation.

Most likely, the Fed has done a better job of convincing the public and financial markets that it really, really means to keep inflation at 2 percent or a little less. From Feroli’s research:

Slack pushes inflation lower but well-anchored inflation expectations prevent that slack from fostering a psychology that leads to a deflationary spiral. Inflation expectations have probably been supported by the Fed’s activist, accommodative polices over the past few years.

With U.S. growth slowing to a trickle in the first half of this year, the jury is still out on the success of the Bernanke Fed’s policies. But the record to date suggests the Great Depression scholar will hold true to a promise he made in an oft-quoted speech in 2002 — that the Fed would never let Japan-style deflation happen in the United States.

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