With increased fiscal spending and novel monetary policy tools being used to revive the economy over the past year, concerns over inflation are hardly new.
But with certain economic indicators pointing toward a possible recovery, more and more people are looking for signals that the Federal Reserve is willing and capable to combat rapidly rising prices in the face of declining purchasing power and rising unemployment.
After leaving a key interbank lending rate unchanged Wednesday, the U.S. central bank indicated its willingness to keep interest rates low for some time and its expectation for inflation to remain "subdued," despite some signs the economy is improving.
The Fed described its longer-term inflation expectations as "stable."
Investors, however, weren’t convinced, apparently afraid that the Fed’s more positive tone signified a prospective rate hike in the near future. Stock markets slid after Wednesday’s announcement and fell further Thursday and Friday.
Gregory Hess, a professor at Claremont McKenna College and a former Fed economist, described the situation as "an inflation-uncertainty problem, not an inflation problem."
"The Fed can fix the uncertainty problem," Hess said, calling for the central bank to articulate an inflation percentage goal to convince the public that it would fight both deflation and hyperinflation. "Stabilizing that expectation would provide a lot of relief to the market."
Most economists agree inflation is more of a long-term worry, though, with many using the phrase "excess capacity" to describe an economy in which too many workers are unemployed and too little production is happening for price increases to be a concern.
According to some economists, the substantial amount of excess capacity could still push down prices and wages at this point. The significant inventory of unsold homes, problems in commercial real estate and signs of more foreclosures to come could put even more downward pressure on prices, said economist James Hamilton, a professor at the University of California, San Diego -- although he doesn’t foresee a broad price collapse.
Others see the deflation risk as a thing of the past.
"I was a lot more worried about that nine months ago than I am now," said economist Ryan Ratcliff, who teaches at the University of San Diego. "Deflation went hand in hand with the idea that this was the second coming of the Great Depression. That danger was largely overblown."
Most agree inflation appears imminent, with many saying it will be at least a year before inflation creeps in, if not longer.
And while many -- including the Fed -- consider some inflation as beneficial for an economy in the throes of a recession, others see inflation as damaging.
Both the federal government and the central bank have "a bias toward inflation," said Brian Simpson, an economist teaching at National University. "They’ve used this recession as an inflationary refueling period … and we all pay in the form of higher prices and lower incomes and, in general, lower standards of living."
According to a recent National Association of Business Economics survey published last month, economists believe the Fed is targeting inflation of 2 percent but think the average of core inflation from 2014-2018 will be closer to 3 percent.
A few local economists interviewed for this article see stagflation as a possibility: an economic situation characterized by inflation coupled with high unemployment and slow growth.
Continued federal budget deficits, heavy-handed regulation, the failure of the education system to cultivate the proper skill sets, and a loss of confidence in the U.S. dollar could create a stagflation environment, said Lynn Reaser, former Bank of America (NYSE: BAC) chief economist and now chief economist at Point Loma Nazarene University.
Other economists listed insufficient demand and overly stimulative monetary and fiscal policy as additional ingredients for stagflation.
"It would not be the stagflation of the 1970s, with double-digit rates of inflation and low economic growth, but it could be sub-par growth (close to 1 percent) but above-par inflation (close to 3 percent)," Reaser said. "It’s not the most likely scenario … but it’s nothing that should be discounted out of hand."
Former Fed economist Hess viewed stagflation as unlikely, saying that there was enough productivity to prevent the severe disruption in supply that typically leads to stagflation.
Where economists vary most, however, is on when and how the Fed will need to address inflation and which signals the Fed should be watching more closely.
For Reaser, the mere expectation that inflation will occur could both accelerate and amplify the event.
"The biggest risk and the biggest unknown is inflation expectations," Reaser said. "If people start to believe inflation could be a problem … they could start to raise prices more actively. Inflationary expectations are the biggest risk rather than actual pressure on prices and wages."
One of the benchmarks the Fed will be watching is watching the market for Treasury Inflation-Protected Securities, or TIPS, a type of Treasury bond that indexes for inflation, Reaser said. A rise in TIPS interest rates and changes in other consumer surveys could induce the Fed to raise interest rates if it felt it had to reassure the public.
For UCSD’s Hamilton, the Fed should be keeping a close watch on the value of the dollar, which has declined over the last several months and driven up prices for goods the United States purchases on the international market, such as oil and raw commodities.
"The Fed made a mistake" last year when it allowed the dollar to slide by continuing to drop interest rates as it worried about unemployment, thus contributing to the climb in oil prices in the summer of 2008.
"That was very destabilizing," Hamilton said.
Economists said a significant increase in consumer spending and bank lending and a rise in longer-term interest rates on 10-year Treasury bonds could also point to inflation.
Most agree the Fed won’t move on interest rates until unemployment stabilizes, and that the timing of a rate boost will be both crucial and complicated. A change in interest rates can take almost nine months to a year to start affecting consumers’ spending behavior, USD’s Ratcliff said.
Raising rates too soon could hinder a recovery, while raising rates too late could fail to adequately control inflation.
Economists vary on their level of confidence in the Fed’s abilities. Some express a great deal of trust in Fed Chairman Ben Bernanke. Others are more skeptical and say the United States relies too much on the Fed to solve its economic problems.
Some see a small rate increase as soon as spring of next year; others see the Fed waiting until it is too late and raising interest rates dramatically.
Some economists are calling for the Fed to map out its plans publicly for guiding interest rates and exiting from its various "quantitative easing" programs, while others say the Fed should allow itself some flexibility to respond quickly and effectively as problems arise.
"The Fed always champions the fact that policy should be transparent, predictable and boring," Hess said. "Not so boring right now."
Daily Transcript Economic Analyst Jenny Ross contributed to this article.
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