Inflation fears are greatly exaggerated

An unexpected jump in May’s consumer price index (CPI) has once again set the inflation hawks on the warpath. For those who don’t remember, these were the people who denounced President Barack Obama’s stimulus program in 2009 because they said it would send inflation soaring. They also attacked the Federal Reserve Board’s quantitative easing program, in which the Fed purchased financial assets from private banks to stimulate the economy, for the same reason. Inflation hawks such as Jeffrey Lacker, president of the Richmond Fed; Alan Meltzer, a distinguished economist; and of course, Barron’s assured us that hyperinflation was just around the corner.

It has now been more than five years since the stimulus began to take effect and more than four years since the first round of quantitative easing, and we still don’t see any signs of hyperinflation on the horizon. But the CPI did rise by 0.4 percent in May, so many of the inflation hawks seem convinced that their time has finally come.

First, it is important to point out that the May rise was driven by unusually large increases in food and energy prices. If we pull out these components and look at the core CPI, the increase was just 0.3 percent in May.

Appealing to the core index always prompts suspicion, but the point of this is to remove volatility — not to lower the measured rate of inflation. There are many months in which food and energy prices fall. As a result, the CPI rose just 0.1 percent in both January and February and fell 0.2 percent in both April and May of 2013. By contrast, the core inflation rate has been virtually unchanged for the last three and a half years.

Even the 0.3 rise in in May was pushed in part by core components that are affected by energy prices. The most noteworthy item in this category was a 5.8 percent increase in airline fares that was driven largely by higher fuel prices.

Furthermore, it would actually be good news if the inflation rate were to rise somewhat. The Fed has set itself a target of 2.0 percent inflation. However, this is an average, not a maximum. The Fed’s preferred inflation measure, the core personal consumption expenditure (PCE) deflator, has risen at an average rate of just 1.4 percent since the economy fell into recession in the first quarter of 2008. This means we can have an inflation rate in the PCE of 2.5 percent for the next five years and still be below the Fed’s inflation target. 

While there may be little basis for concern about inflation, there are considerable grounds for concern about weak growth, and this was true even before the release of data showing the economy shrank at a 2.9 percent annual rate in the first quarter of 2014. At 6.3 percent, the unemployment rate has fallen considerably from its recession peak of 10.0 percent, yet most of this decline is attributable to people leaving the labor market.

The employment to population ratio (EPOP), the percentage of the population that is employed, is still 4.0 percentage points below its prerecession level, implying a decline in employment of 10 million. The aging of the population is often blamed for the drop in the EPOP, but most of the decline is attributable to prime age workers (people 25 to 54) leaving the labor market. Their sudden decision to leave the labor market can be explained only by a lack of employment opportunities.

By the Congressional Budget Office’s calculations, the economy is still almost 6 percent below its potential. The growth rate for 2014 is likely to be close to 2.0 percent, which is below the economy’s potential growth rate, meaning that it is making up none of the gap between potential GDP and actual GDP.

In this context, it would seem that the Fed’s work should be simple: It should be doing everything it can to boost the economy, with little concern about raising the inflation rate. Unfortunately, not everyone at the Fed holds this view. Several of the district bank presidents, who sit on the Fed’s Open Market Committee, which sets interest rates, have expressed concern about inflation and argued that the Fed should slow the economy to keep inflation low. For example, just after the bad news on the revised first quarter GDP data was released, James Bullard, president of Federal Reserve Bank in St. Louis, indicated that he thought the Fed would have to raise interest rates early next year.  

The problem with high Fed officials such as Bullard calling for rate hikes is that it makes it more acceptable to raise rates and slow the economy even when millions of people are still needlessly unemployed or underemployed. It can also create a situation in which inflation doves, such as Fed Chairwoman Janet Yellen, feel pressure to go along and raise interest rates despite the evidence.

This points to the urgency of filling the remaining open seat on the Fed’s Board of Governors with an inflation dove who can support Yellen. Obama should have a good list of candidates for the slot. His former top adviser Christine Romer would be a fine choice, if this is not seen as a demotion for someone who had chaired the Council of Economic Advisers. Another fine pick would be John Hopkins professor Lawrence Ball. I would also throw in my friend and co-author Jared Bernstein, who served as Vice President Joseph Biden’s chief economist.

There are others who could be added to this list, but it is important that Obama appoint someone who will oppose using the Fed’s power to shut down the recovery in a misguided attempt to rein in inflation. It is essential that we put more people to work and strengthen the labor market. We need people at the Fed who see job growth as a good thing.