In its September 21 meeting, the Federal Reserve Open Market Committee
expressed concern that the rate of inflation is far too low. According to the
minutes some members of the FOMC have said,
that unless the pace of economic recovery strengthened or underlying inflation
moved back toward a level consistent with the Committee's mandate, they would
consider it appropriate to take action soon. With respect to the statement to
be released following the meeting, members agreed that it was appropriate to
adjust the statement to make it clear that underlying inflation had been
running below levels that the Committee judged to be consistent with its
mandate for maximum employment and price stability, in part to help anchor
inflation expectations. … The Committee was prepared to provide additional
accommodation if needed to support the economic recovery and to return
inflation, over time, to levels consistent with its mandate.
Meanwhile, on Friday, October 15, Federal Reserve chairman Ben Bernanke
hinted that the US central bank is ready to push more money into the economy
in order to reverse the present slide in the growth momentum of the consumer
price index. He said that the low level of inflation presented a risk of
deflation. "There would appear, all else being equal, to be a case for
further action," Bernanke said at a conference sponsored by the Boston
Federal Reserve Bank.
The yearly rate of growth of the consumer price index (CPI) stood at 1.1
percent in September against 1.1 percent in the month before and 2.6 percent
in January. The yearly rate of growth of the CPI less food and energy — the
core CPI — stood at 0.8 percent last month versus 0.9 percent in August and
1.6 percent in January — well below the 2 percent level of the unofficial Fed
target, which is considered to be consistent with price stability.
The popular way of thinking maintains that a policy of price stability
doesn't always imply that the central bank must fight inflation. It is also
the role of the central bank to prevent large falls in the rate of inflation,
or an outright decline in the general price level. Why is that so? Because it
is held that a fall in the price level, labeled price deflation, postpones
consumer and business expenditure and thereby paralyzes economic activity.
Moreover, a fall in price inflation raises real interest rates and thereby
further weakens the economy. Additionally, as expenditure weakens, this
further raises unutilized capacity and puts further downward pressure on the
price level. Most economists are of the view that it is much harder for the
central bank to handle deflation than inflation. When inflation rises it is
argued the central bank has no limit as such on how much it can raise
interest rates to "cool off" the economy. This is, however, not so
with regard to deflation. The lowest level that the central bank can go to is
a zero interest-rate level.
For instance, let us assume that Fed policy makers have reached the
conclusion that, in order to revive the economy, real interest rates must be
lowered to a negative figure. This, however, may not always be possible to
accomplish, so the argument goes.
When nominal or market interest rates are at a zero level it is not
possible to make real interest rates negative when the price level is
falling. Here is why.
From the popular definition that
nominal interest rate = real interest rate + percent change in price
level,
it follows that
real interest rate = nominal interest rate − percent change
in price level.
Hence, when nominal interest rate is 0 and the price level falls by 1
percent,
real interest rate = 0 + 1 percent.
As the pace of deflation intensifies, the increase in real interest rates
also intensifies. In this situation the Fed's interest-rate weapon becomes
ineffective. For instance, in order to lower real interest to −0.5 percent
the central bank would need to lower nominal interest rates to −1.5 percent
(real interest rate = −1.5 percent + 1 percent = −0.5 percent). Obviously,
this cannot be done, because no one would lend in return for a negative
nominal interest rate — people would rather hold the money, so it is argued.
Likewise, when the rate of inflation is very low it can also create
problems. Suppose that on account of weak aggregate demand, inflation has
fallen from 2 percent to 1 percent. Within this setup the central bank can
only target a real interest rate of −1 percent. It cannot aim at a lower real
interest rate since this would imply setting nominal interest rate below zero
(−1 percent = 0 percent − 1 percent). In order to target for real interest
rate of −1.5 percent nominal rate must fall to −0.5 percent (−1.5 percent =
−0.5 percent − 1 percent).
Similarly as the economy weakens further and inflation falls to 0.5
percent this will not allow the central bank to target real interest rates to
below −0.5 percent. In short, deflation, or low inflation, reduces a central
bank's flexibility in reviving the economy.
Hence, it is argued, the policy of price stability must aim at a certain
level of inflation that will give the central bank the flexibility to keep
the economy on the growth path of economic prosperity.
So what should this level of inflation be? Some experts are of the view
that 2 percent to 3 percent is the best range. (Fed officials are of the view
that 2 percent is the right figure.) The essence of all this is that a little
bit of inflation is a must in order to have economic prosperity and
stability.
According to this way of thinking the inflationary buffer must be big
enough to enable the Fed to maneuver the economy away from the danger of
deflation, or so it is held.
As a rule a general increase in prices comes on account of the increase in
money "out of thin air." An increase in money out of thin air leads
to an exchange of nothing for something, or to the economic impoverishment of
wealth generators. So how in the world can price inflation of 2 percent to 3
percent, which is called buffer inflation, promote economic growth and prosperity?
It is absurd to regard a price inflation of 2 percent as some kind of
optimum.
Contrary to popular thinking, it is not a fall in prices as such that
weakens real economic growth but the declining pool of real savings. (The
declining pool weakens the process of real-wealth generation.)
Now the conventional thinking is of the view that individuals will not
lend at negative nominal interest rate. For some strange reason mainstream
thinkers hold that the Fed could target negative real interest rates and individuals
will be happy to lend at these rates. We suggest that mainstream thinkers
have reached this erroneous conclusion as a result of a misleading view
regarding what the real interest rate is all about.
The real interest rate is not the difference between the nominal rate and
the change in the CPI; it is actually the rate of exchange between present
goods and future goods. Also, there is no such thing as the real
interest rate — there are a multitude of real rates, which cannot be added to
a total.
Since monetary pumping undermines the formation of capital and weakens
economic growth, it actually leads to a higher rate of exchange between
present to future goods. (As people get poorer, the importance they assign to
present goods increases — the real interest rate increases.)
A so-called lowering of "real" interest rates by means of money
pumping is basically an act of a diversion of real wealth from wealth
generators to various nonproductive activities. Hence, contrary to popular
thinking, the Fed's attempt to lower the real interest rate in fact leads to
a higher real interest rate. (The Fed does not have control over people's
time preferences.)
It is a fallacy to hold that an increase in the pace of inflation will
revive the economy. If the pool of real savings is falling, then even if the
Fed were to be successful in dramatically increasing the price level the
economy would follow the declining pool of real savings. In this situation
the more money the Fed pushes to the economy the worse the economic
conditions become. Again, pumping more money only weakens the
wealth-generating process.
Conclusion
In its September 21 meeting Fed officials expressed concern that the US
rate of inflation is far too low. Also, on Friday the Fed chairman hinted
that the US central bank is ready to push more money to reverse the slide in
the growth momentum of the CPI in order to revive the economy. We suggest
that if the pool of real savings is declining then, even if the Fed were to
be successful in dramatically increasing the price level, the economy will
follow the declining pool of real savings. In this situation, the more money
the Fed pushes the worse the economic conditions become.
