Captain Bernanke's Blimp


To understand why the Fed chairman spends so much time worrying about inflation, not housing or the stock market, imagine taking a certain ride with him

To understand why Federal Reserve Chairman Ben Bernanke worries so much about inflation, think of him as the captain of an enormous blimp that's secured at 50 feet above the ground. Bernanke doesn't want his blimp to deflate and crash, of course. But what he's most worried about right now is that his blimp, which symbolizes inflation expectations, will break free and soar up to the stratosphere.

There. Now you know why Bernanke spends so much time thinking about what's in the minds of the public on the topic of inflation. Captain Bernanke knows that if the headline rate of inflation remains high for too long, people start adjusting their long-run expectations, figuring that higher inflation is here to stay. When that happens, shopkeepers are quicker to raise prices, workers demand bigger raises, and prices begin spiraling upward. The blimp breaks its tethers. In the unlikely worst case, hyperinflation ensues.

That's what Bernanke had in mind when he testified Nov. 8 (BusinessWeek.com, 11/8/07) that expectations of future inflation appear "reasonably well anchored" so far. Fretfully, though, Bernanke noted to the Joint Economic Committee of Congress that oil and other commodity prices were rising, and the dollar was losing value (BusinessWeek.com, 11/8/07).

Inflation Factors

Those things tend to push up overall prices and feed into expectations of more inflation to come. As the Fed chairman put it, members of the Federal Open Market Committee concluded at their Halloween meeting that oil, other commodities, and the cheap dollar "were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well."

Stock market investors have been skittish about the impact of high oil prices, a weak dollar, a soft housing market, and ongoing troubles in the financial sector. The Dow Jones industrial average plummeted 360 points on Nov. 7 (BusinessWeek.com, 11/7/07), sparked by declines at Fannie Mae (FNM), Freddie Mac (FRE), and Washington Mutual (WM). On Nov. 8, Cisco Systems (CSCO) fueled fears that corporate spending could slow, leading tech stocks such as Research In Motion (RIMM) and Oracle (ORCL) lower.

"Moored" or "Unmoored"

So are inflation expectations moored or unmoored, to stick with Bernanke's vocabulary? The best way to tell is to look at the bond market. Specifically, the spread between the rates on ordinary Treasury bonds and the rates on inflation-protected Treasury securities. The idea is simple: If ordinary bonds have a higher yield than bonds that are protected for inflation—which they always do—the difference must be what investors are demanding to compensate for the ravages of inflation.

On that score, it appears that inflation expectations remain pretty well moored. At current bond prices, there's roughly a 2.4 percentage point gap in yields between 10-year Treasury inflation-protected securities and plain old Treasuries, meaning that people are expecting inflation to average around 2.4% a year for the next decade. Not too bad. Back in 2004 and 2005, the gap got as big as 2.6% or 2.7%.

But as the nation's central bank, the Federal Reserve can't take any chances. Bernanke reiterated to Congress that he still sees inflation as a risk as big as a slowdown in the economy's growth rate. This is one captain who's determined not to let his blimp escape.

Coy is BusinessWeek's Economics Editor .

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