16 Jan 2010

Mankiw Gives Himself an Out on Inflation

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Phil Maymin emails me Mankiw’s op ed and wants commentary. Some excerpts:

IS galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple.

Let’s start with first principles. One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods.

A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall.

To be sure, we have large budget deficits and ample money growth. The federal government’s budget deficit was $390 billion in the first quarter of fiscal 2010, or about 11 percent of gross domestic product. Such a large deficit was unimaginable just a few years ago.

The Federal Reserve has also been rapidly creating money. The monetary base — meaning currency plus bank reserves — is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years.

Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn’t terribly worried about inflation. What gives?

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

Now Phil was exasperated by the part I put in bold, thinking that Mankiw was saying good intentions will somehow neutralize money’s ability to raise prices. I think Phil is correct that Mankiw is being very naive here–in fact I have a Mises Daily coming out soon which shows how the Fed’s operations really are equivalent to a king running the printing press to cover the budget deficit.

However, just to clarify, what Mankiw means is that investors aren’t freaking out (yet) because they think Bernanke is only doing what he needs to, to rescue the economy. So they view the recent growth in the monetary base as a one-off event, as opposed to a willingness of the Fed to cover health care reform and Social Security.

Mankiw then goes on to talk about the Fed’s ability to rein in price inflation when the time comes, through selling off assets and paying higher interest rates on excess reserves. I have dealt with Mankiw’s views in this article.

But what intrigues me about Mankiw’s latest is this conclusion:

Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.

I think those of us not in the annals of power forget the constraints that these guys (and gals) are under. If Mankiw thinks we’re screwed, he can’t just come out and say it.

Instead, he has to give a very neutral, let’s-cover-all-the-bases article, and then almost as an afterthought say, “By the way, yields on bonds right now are insane.”

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