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4 The Regional Economist | January 2010

May Be the Next Dragon
To Slay
By Kevin L. Kliesen

B y most metrics, the recent recession was the longest and

deepest since the 1930s. Some analysts believe that the Fed-
eral Reserve’s and the federal government’s aggressive actions to
assist and stabilize the economy and fragile credit markets pre-
vented an even worse outcome than actually occurred. Now, with
economic and financial conditions on the mend, many analysts
are turning their attention to the legacy of these actions.
Foremost among the concerns of many is how to design a strat-
egy that does not on the one hand raise interest rates prematurely,
thereby prematurely nipping the economic recovery in the bud,
while on the other hand does not keep rates too low for too long,
thereby creating conditions that lead to a surge in inflation or
inflation expectations. What’s needed is an effective policy to
illustration by t yson mangelsdorf w w

prevent the unprecedented monetary stimulus from becoming a

destabilizing influence on price stability. Another key is accurately
predicting inflation over the next few years.

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FIGURE 1 Two key points are worth noting. First, the
The FOMC’S Federal Funds Target Rate and the Monetary Base Fed began reducing its federal funds rate in
September 2007, about a month after condi-
INDEX, JANUARY 2007 = 1.0
tions began to deteriorate in the short-term
money markets. Although the FOMC con-
2.00 tinued to reduce its interest rate target before
1.75 and shortly after the crisis of Bear Stearns
1.50 in March 2008, the target then remained on
1.25 hold from May to September, as rising oil and
Monetary Base
Federal Funds Target gasoline prices pushed up headline inflation
0.50 to levels not seen since early 1991. In Septem-
0.25 ber 2008, though, economic and financial
0.00 conditions deteriorated sharply, causing the
January 07 July 07 January 08 July 08 January 09 July 09
Fed to quickly reduce its interest rate target to
NOTE: Vertical lines mark key times in the financial crisis: August 2007, March 2008 and September 2008. nearly 0 percent (technically, a range from 0
SOURCE: Author’s calculations using Federal Reserve data. to 0.25 percent).
The second takeaway from Figure 1 is
Some analysts believe that inflation will that the Federal Reserve did not begin to
remain low as long as the unemployment aggressively expand the monetary base until
rate stays well above its natural rate of September 2008.3 Prior to then, the Federal
unemployment (a measure of slack). Others, Reserve was aggressively lending to domestic
by contrast, believe that the risk of higher and foreign banks and financial institutions,
inflation has risen sharply because of the but at the same time it was countering this
Fed’s large-scale asset purchase program and expansion in bank reserves through offset-
the advent of large, and possibly protracted, ting sales of Treasury securities in its portfo-
budget deficits. lio. This is known as sterilization because it
prevents an increase in the monetary base.
Recent Policy Actions The Fed’s sterilization efforts ended in Sep-
In some ways, the 2007-09 recession was tember 2008, when financial markets expe-
the most severe since the 1930s. The latest rienced considerable disruption associated
recession lasted probably a little less than with the government’s takeover of Fannie
two years, roughly double the length of the Mae and Freddie Mac, the failure of Lehman
average post-World War II recession (10 Brothers and the near failure of American
months).1 As yet, though, the unemploy- International Group (AIG). At that point,
ment rate remains below its post-World War more than any other in the crisis, economic
II peak of 10.8 percent, which was reached in activity began to decline sharply and rapidly.
November and December 1982. By August 2009, the monetary base had risen
Given the severity of the latest recession, it to a level that was slightly more than double
was not surprising that government policy- its level in January 2007, while the FOMC
makers were aggressive and innovative in had reduced its federal funds target rate by
their response to it. Figure 1 shows two key nearly 100 percent. Despite a doubling in the
measures of the response taken by Federal stock of high-powered money, the M2 mea-
Reserve policymakers during this period. sure of the money supply increased by only
In Figure 1, the path of the FOMC’s 17 percent over the same period.4
federal funds interest rate target is plot- The surge in the monetary base has not
ted along with the monetary base. The increased the money supply to the same
monetary base, which is sometimes called extent both because the demand for loans
“high-powered money,” can be thought of as has been weak and because some banks
the raw material for creating money.2 Since have been reluctant to extend credit. On the
both series are denominated differently, the demand side, loan growth has been anemic
chart indexes the series to be 1.0 in January because the demand for credit typically
2007. The chart also includes vertical lines weakens during a recession—especially
at August 2007, March 2008 and Septem- during a long and deep recession. On the
ber 2008, when key events occurred in the supply side, many banks have become more
financial crises. circumspect in their lending practices in the
6 The Regional Economist | January 2010
aftermath of the financial boom and bust. FIGURE 2
The latter could also reflect the concerns Measuring Disagreement among Forecasters about the View of CPI Inflation over the Next Five Years
of bank regulators, who are charged with 6
ensuring the safety and soundness of the Disagreement Top 10 Bottom 10
banking system, and could stem from bank-
ing laws that require banks to meet mini- 4

mum capital requirements. 3

The Best Way To Forecast Inflation? 2

Figure 1 shows the primary reason why 1

many economists and financial market par- 0
October 2009

ticipants worry about the potential for much 1986 1989 1992 1995 1998 2001 2004 2007

higher inflation rates going forward: The NOTE: Disagreement is measured as the difference between the least optimistic forecasters (top 10 average) and the most optimistic
forecasters (bottom 10 average).
monetary stimulus will eventually lead to a
SOURCE: Blue Chip Economic Indicators, various issues
rebound in economic activity and an increase
in the demand for bank loans and, thus, faster
growth of the money supply. As price pres-
sures begin to build during the recovery—in about the medium-term inflation outlook. inflation rate depends on (i) the inflation
part because firms find it easier to raise prices By contrast, during periods when inflation rate expected over some horizon and (ii)
and they must compete for labor, capital and tends to be relatively low and stable, such the amount of slack in the economy. The
materials—inflation and the inflation expecta- as the mid-1990s to mid-2000s, forecasters amount of slack is also often measured as the
tions of firms and households may begin to tend to disagree less about the inflation difference between actual real GDP and an
increase. These inflation expectations may outlook. Since early 2007, though, the level estimate of potential real GDP; this is termed
be exacerbated if markets believe that the Fed of inflation disagreement among forecasters the output gap. This view also seems to hold
is not withdrawing the monetary stimulus has increased. sway among several members of the Federal
in a timely fashion, thereby leading to higher Ultimately, one’s view of the inflation Open Market Committee.
future inflation rates. outlook over the next few years depends on As discussed by St. Louis Fed President
A considerable amount of disagreement one’s view of how best to forecast inflation James Bullard, the New Keynesian model
seems to exist among economists about the over that horizon. Economists use numer- has a few well-known problems as it relates
inflation outlook over the next few years. ous methods to forecast inflation. Some to forecasting inflation. 6 One problem
Some economists are quite worried about the economists believe that the growth rate of is that the output gap is often subject to
potential for much higher inflation, while the money supply is an accurate predic- considerable measurement error, as well as
others are more concerned about the poten- tor of inflation. According to this view, being revised often because of revisions to
tial risk of inflation falling to uncomfortably popularized by monetarists, the inflation real GDP and to estimates of the economy’s
low levels—or even the possibility of deflation rate will ultimately be determined by the underlying rate of productivity growth.
(a fall in the aggregate price level). Much of growth rate of the money supply relative to The latter affects estimates of potential real
this disagreement reflects, on the one hand, the growth rate of real GDP. When money GDP and, thus, the output gap. As a result,
the Federal Reserve’s aggressive response to growth exceeds real GDP growth—what policymakers are often confronted with
the deep recession, the financial crisis and Milton Friedman and others have commonly considerable uncertainty about the size
the exceptionally large federal budget deficits, denoted as too much money chasing too few of the gap as they deliberate the stance of
and on the other hand, the downward pres- goods—the inflation rate will increase. To monetary policy.
sure on wages and prices that typically occurs other economists, the inflation process is Many New Keynesian economists assume
in the aftermath of a deep recession. a random walk, which simply means that that the output gap matters more than
Figure 2 depicts one way to gauge this today’s inflation will be tomorrow’s inflation. the expected inflation rate for determin-
disagreement. In Figure 2, the history of the Thus, if inflation is 1 percent in 2009, then ing today’s inflation. That assumption has
Blue Chip forecasts of the average Consumer the best forecast for inflation in 2010 is 1 per- been questioned by some economists, who
Price Index (CPI) inflation rate over the cent. This view has been shown to produce instead believe that the public’s expectation
next five years is presented. The chart shows fairly accurate forecasts.5 of future inflation, in part determined by
the average of the least optimistic inflation According to an August 2009 survey, actions of the Federal Reserve, matter more
forecasts and the most optimistic inflation nearly two-thirds of professional forecast- than the degree of economic slack currently
forecasts, as well as their difference (disagree- ers surveyed by the Federal Reserve Bank in the economy.7
ment). During periods when inflation tends of Philadelphia use some variant of the
to be relatively high and variable, such as the Phillips Curve to forecast inflation. The Potential Inflation Risks
late-1980s and early 1990s, there tend to be Phillips Curve is now often known as the Despite some disagreement about the
some sizable differences among forecasters New Keynesian model. In this view, today’s inflation outlook over the next few years, the
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inflation risks stemming from the govern- believe. If so, those who foresee little risk
ment’s policy responses to the financial crisis to the near-term inflation outlook because
and the so-called Great Recession will prob- of a large, persistent output gap may be
ably not be immediately known because too optimistic.
the economy is regularly hit by unforeseen
shocks (such as large increases in oil prices), Reinflating Asset Prices
foreign economic developments and the The period following the 2001 recession is
legacy of past policy actions. Still, there are an example of how the economy can evolve
“ . . . the size of the output several potential risks to the medium-term in ways not readily expected. Recall that
inflation outlook that can be identified. Of during the economic recovery following the
gap might be smaller than course, these risks must be balanced against recession, job growth remained consistently
conventional wisdom might the Federal Reserve’s commitment to negative until September 2003—nearly
maintaining a low and stable inflation rate. two years after the recession ended. At the
believe. If so, those who Indeed, the Fed can help anchor inflation same time, the core inflation rate was falling
foresee little risk to the expectations at a low level both through its sharply. From December 2001 to December
words and deeds. 2003, the year-to-year change in the core
near-term inflation outlook CPI fell from about 2.75 percent to about 1
Is the Output Gap Smaller than We Think? percent. To confront the possibility of “the
because of a large, persistent It is highly likely that this recession will risk of inflation becoming undesirably low,”
output gap may be too induce considerable structural change in the the FOMC announced at the conclusion of its
economy. Indeed, this development already Aug. 12, 2003, meeting that its low-interest
optimistic.” appears to be in train since many economic rate policy would be “maintained for a con-
resources—labor and capital—that were siderable period.” In practice, this meant that
employed in the automotive, housing and the FOMC maintained its intended federal
financial industries will need to migrate to funds target rate at 1 percent until the June
industries that offer higher rates of return. 30, 2004, meeting.
One way to gauge the evolving structural Although it is often easy to criticize policy
change is by viewing the percentage of after the fact, some economists subsequently
the labor force that is often characterized concluded that the extended period of low
as the long-term unemployed (persons interest rates created a credit boom that
unemployed for 27 weeks or longer). As of started—and prolonged—sharp increases in
November 2009, this percentage had risen financial assets and commodity and house
to 3.8 percent, its highest rate in the post- prices that put upward pressure on prices
World War II period. paid by consumers and businesses.8 The
Those who believe that the Phillips sharp increase in oil and commodity prices
Curve framework can adequately capture was especially acute. Following increases
the evolution of the inflation outlook over that averaged about 2.25 percent from 2001
the near term must adequately account for to 2003, the CPI inflation rate averaged 3
structural changes that might have occurred percent from 2004 to 2007; the run-up in
in the boom and bust in asset prices. In its oil prices to more than $130 per barrel then
2009 Annual Report, the Bank for Interna- caused CPI inflation to accelerate sharply,
tional Settlements discussed these “bubble- averaging 5 percent over the first three quar-
induced distortions” to current estimates ters of 2008.
of trend output growth and, hence, poten- In some respects, the Fed faces a similar
tial real GDP. Thus, it is conceivable that problem today: Policy is extraordinarily
estimates of potential real GDP at the start accommodative (see Figure 1), and the
of the recession were too large and that the FOMC has said that “economic conditions
structural adjustments noted above may are likely to warrant exceptionally low lev-
have subsequently reduced potential real els of the federal funds rate for an extended
GDP from its artificially high level. period.” Although low interest rates are a
While it is probably unlikely that the fall key part of the FOMC’s strategy to boost
in actual real GDP during the recession has economic growth and cement the health of
been matched by the fall in potential real the economic recovery, there might still be
GDP, the size of the output gap might be a danger of inflating asset prices by encour-
smaller than conventional wisdom might aging investors and speculators to shift out
8 The Regional Economist | January 2010
of low-yield assets like Treasury securities percent see little or no risk; the remainder see ENDNOTES
into higher-yielding assets like commodity only a moderate risk.10 1 The National Bureau of Economic Research,
contracts or other tangible financial assets. which dates business cycle peaks and troughs,
The Fed’s Strategy usually waits several months after the apparent
end of the recession to declare the date of the
The Exploding Federal Budget Deficit A key difference between the 2003-04 trough.
2 In essence, high-powered money (the sum of
From fiscal year 2002 to 2008, the U.S. episode—when the Fed held its federal
bank reserves and currency in circulation) is
federal budget deficit averaged about $305 funds interest rate target at 1 percent from used to create bank loans, which expand the
billion per year, or 2.5 percent of GDP. In June 2003 to June 2004—and today is that supply of money.
3 See Gavin for a detailed discussion of changes in
fiscal year 2009, though, the federal deficit the FOMC has used innovative measures
the monetary base during this period.
totaled about $1.5 trillion, or roughly 11.25 to dramatically expand the size of its bal- 4 Broadly, M2 is the sum of currency, checkable

percent of GDP, according to estimates by the ance sheet.11 Because this expansion in the deposits, savings and small-time deposits, and
retail money market funds. For a description and
U.S. Congressional Budget Office (CBO). The monetary base has the potential to greatly definition of the monetary and financial terms
large increase in the deficit reflected legisla- expand the nation’s money supply when used throughout this article, see http://research.
tive policy actions such as the American economic activity rebounds, policymak- 5 See Atkeson and Ohanian.
Recovery and Reinvestment Act of 2009 (fis- ers are, thus, confronted with the potential 6 See Bullard’s presentation at http://research.

cal stimulus) and the Troubled Asset Relief problem of designing an effective policy to
Program (TARP), as well as an increase in reduce the size of the Fed’s balance sheet 7 See Piger and Rasche.
mandatory government outlays associated to prevent a rapid acceleration in money 8 See Taylor and Frankel.
9 See Congressional Budget Office.
with the deep recession. The CBO projects growth that may destabilize inflation 10 The Blue Chip Survey asked forecasters to gauge
that the federal budget deficit will total nearly expectations. Improving economic and their risk of sharply higher inflation on a scale
$1.4 trillion in fiscal year 2010 and nearly financial conditions have lessened the use of of one to five, with one being “no risk” and five
signaling “great risk.”
$925 billion in fiscal year 2011.9 the Fed’s special lending facilities; so, some 11 See United States Financial Data to view updated
Gauging the deficit’s potential effect on portion of these excess reserves will naturally charts of the asset and liability side of the Fed’s
inflation depends on how it is financed. contract on their own. Still, this process balance sheet. These charts can be accessed at
To see this, consider the government’s will not be sufficient to prevent a potentially page7.pdf.
budget constraint. In its simplest form, destabilizing surge in money growth, which 12 See Bernanke.

the constraint stipulates that if the deficit means that Fed policymakers will have to
is not financed by higher taxes, it must be adopt other, more aggressive strategies. The
financed in one of two ways: (i) by issuing officials have discussed several methods of Atkeson, Andrew; and Ohanian, Lee E. “Are
Phillips Curves Useful for Forecasting Infla-
debt to the public, which includes foreign doing this, including paying interest on bank tion?” Federal Reserve Bank of Minneapolis
holders of U.S. Treasury securities; or (ii) by reserves, using conventional open market Quarterly Review, Winter 2001, Vol. 25, No. 1,
pp. 2-11.
selling government debt to the central bank, operations and selling outright some of the
Bank for International Settlements. “79th
which is the Federal Reserve. The latter, also securities and other assets held on the Fed’s Annual Report: 1 April 2008-31 March 2009.”
called monetization of the debt, increases balance sheet.12 Regardless of the method Basel, Switzerland, June 29, 2009.
Bernanke, Ben. “The Federal Reserve’s Balance
the monetary base (high-powered money) used, an improving economy means that the Sheet: An Update.” At the Federal Reserve
and, thus, the money supply. For example, Fed must be prepared to raise its interest rate Board’s Conference on Key Developments in
the Federal Reserve announced March 18, target to prevent an unwanted expansion in Monetary Policy, Washington, D.C., Oct. 8,
2009, that it would buy up to $300 billion money growth by the banking sector. Congressional Budget Office. “The Budget and
of Treasury securities (beyond its existing Fed Chairman Ben Bernanke and other Economic Outlook: An Update.” The Con-
gress of the United States, August 2009.
holdings at the time). These purchases, senior Fed officials are quite confident that Frankel, Jeffrey. “Comment: Real Rates Key to
which were designed to “help improve they have the tools and the determination Commodities Prices,”, March
conditions in private credit markets,” were necessary to prevent an unwelcome accel- 2008. See
not sterilized—that is, they were allowed to eration in inflation or inflation expecta- geNumber=1&virtualBrandChannel=0&sp
increase total bank reserves and, thus, the tions. Unlike previous episodes, though, =true.
Gavin, William T. “More Money: Understand-
monetary base. the magnitude of the policy responses to
ing Recent Changes in the Monetary Base.”
Many economists appear to be concerned the financial crisis and the Great Recession Federal Reserve Bank of St. Louis Review,
about the inflationary implications of the suggests that the FOMC’s margin of error March/April 2009, Vol. 91, No. 2, pp. 49-59.
Piger, Jeremy M.; and Rasche, Robert H. “Infla-
huge increase in government deficit spending seems much smaller than at any time in the tion: Do Expectations Trump the Gap?”
that is unfolding. According to a survey pub- Fed’s history. International Journal of Central Banking,
lished in the June 2009 Blue Chip Economic December 2008, Vol. 5, No. 3, pp. 85-116.
Taylor, John B. “Getting Off Track: How Gov-
Indicators, about 42 percent of forecasters see ernment Actions and Interventions Caused,
a relatively high risk that U.S. inflation will Prolonged, and Worsened the Financial
Kevin L. Kliesen is an economist at the Federal Crisis.” Stanford, Calif.: Hoover Institution
rise sharply within the next five years because Reserve Bank of St. Louis. For more on his work, Press, Stanford University, 2009.
of the government’s and the Fed’s response to see
the financial crisis and recession; another 34 Douglas C. Smith provided research assistance.

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