The Federal Reserve is expected to stop buying long-dated bonds this October. We’ll spend decades deciding whether the program was a success, but one huge worry—that it would cause lots of inflation—didn’t materialize. Nobelist Paul Krugman mocks those who worry about inflation, likening them to climate-change deniers. At the same time, in a survey of chief investment officers, 66 percent cited inflation as a major concern in 2013. Could they be as ignorant as Krugman suggests?
There’s a disconnect here. It’s one thing to fret about inflation itself. A separate concern is inflation risk. Some inflation is actually good for an economy. Inflation risk, on the other hand—not knowing what it will be in the future, or a lack of confidence in your prediction—can be destructive. It makes it harder to set wage contracts, decide how much to spend, how much to produce, and what to charge.
Creditors or pension funds often hedge inflation risk; uncertainty makes that process more expensive. They also have to worry about inflation far into the future. Inflation expectations matter because they, more than current inflation, determine prices. That’s why even if actual inflation doesn’t materialize, the wide range of expectations still matters. When evaluating the costs of the Fed’s quantitative easing program, the relevant question is not whether it sparked inflation. It’s whether it increased inflation risk.
The market would suggest it hasn’t. In a 2012 survey of 31 economic forecasters, almost 75 percent said they expect the Fed will keep inflation low for the next 10 years. The figure below, from the Cleveland Fed, shows what the market expects inflation to be, on average, for the 10 years, as well as the current inflation risk premium (an indicator of the level of inflation risk). Expected inflation has been falling since the early 1980s. The risk premium has been stable.
So everything is fine, right? Not quite. We’ve had low, stable inflation for decades, a feat that is arguably the greatest triumph of modern central banking. But it seems arrogant to assume we’ve kicked inflation risk for good. The youngest career investors who can personally remember periods of high inflation are now in their sixties. It seems possible that it’s been so long since we experienced inflation risk that we may not recognize it.
Barring a large, unpredictable increase in commodity prices, the best-case scenario could be small, predictable inflation—as long as the Fed is committed to it. That’s an open question. Paul Volcker was willing to take the economy into recession to fight inflation. That caused a lot of pain; it also bought the Fed credibility. It’s hard to imagine Janet Yellen going that far.
Even if this program of quantitative easing never results in high inflation, if it cost the Fed its credibility, inflation risk could be a bigger problem than market prices suggest. We’ve forgotten the havoc that inflation risk creates in bond markets, making it more expensive to borrow, and in currency markets, impeding trade. You can’t blame those who remember for worrying now, especially since they may be nearing their fixed-income, retirement years—precisely when inflation risk can do the most damage.