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Economic Forecasts

Inflation Can’t Get Off the Ground

Prices are barely rising despite the Fed’s easy-money policy.

When the federal reserve Board first stepped in to stimulate a crisis-ravaged economy in 2008, inflation hawks went on high alert. The Fed’s quantitative easing—a first-of-its-kind bond-buying program designed to push down long-term interest rates, ease borrowing and fuel growth—was bound to ignite inflation. In what is now the third iteration of QE, $85 billion a month is sloshing into the economy.

But inflation, far from roaring, has barely whimpered. Medical costs and food, apparel and gas prices have all been falling or rising slowly, offsetting a significant hike in housing costs. The consumer price index shows prices rising at an extremely modest 1.4% annual rate. And the inflation gauge preferred by the Fed, known as the core personal consumption expenditures deflator (which excludes food and energy), is as low as it has been since the government started tracking the data in 1960. Hovering at 1.1%, it is far below the Fed’s 2% target.

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Investors flooded into Treasury inflation-protected securities in recent years, accepting negative yields at times in exchange for the government’s inflation shield. An index of TIPS is down 8% so far this year. Gold, the ultimate inflation hedge, is down 37% from its 2011 peak. Growth in prices is so subdued that economic worrywarts occasionally bring up the d-word: They wonder if deflation—a spiral of falling profits, wages and demand—could lead to stagnation of the sort that Japan has suffered for decades.

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Why has inflation been a surprising no-show? Astute students of the economy shouldn’t have been surprised, says economist Mark Zandi, of Moody’s Analytics, given slow worldwide economic growth that has subdued wage hikes. Yes, Economics 101 teaches that boosting the money supply fuels inflation. But the route isn’t always direct from point A to point B, says Zandi. The Fed injects money (in the form of increased bank reserves, in the case of QE), which creates credit, then growth, jobs, low unemployment and, finally, wage growth—which only then stimulates inflation. “It’s a long road between money and inflation. In this case that road has had potholes, fallen bridges—all kinds of impediments that have made the process more attenuated.”

And inflation might not be as quiescent as recent readings suggest. For example, the big drop in medical costs—traced to health reform and, more recently, lower Medicare and Medicaid reimbursements because of Washington’s forced spending cuts—may prove temporary. Commodity prices will pick up when the global economy does.

Most economists expect inflation in the 2% range by next year. But even as demand grows along with the economy, continued global competition and improvements in productivity will keep inflation modest, says economist Edward Yardeni, of Yardeni Research. “Technology is a tremendous booster of productivity—and technology itself continues to get more powerful and cheaper,” says Yardeni.

For investors, that means inflation hedges probably aren’t the place to be now. Consumers, however, should relish rock-bottom prices, which, at least for now, are growing more slowly than our paychecks.

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