Inflation Is Nowhere to Be Seen

Worries about the Fed "printing money" haven't proved valid—yet.

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Critics of the Federal Reserve have been warning for four years that the aggressive monetary policy the Fed initiated in 2008 would inevitably lead to runaway inflation. So far, the Fed has decisively proved them wrong.

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The latest numbers show that inflation actually fell toward the end of 2012, mainly because energy prices plunged. Overall, the annual rate of inflation is only about 1.8 percent, which is even less than the Fed's working target of 2 percent. Some economists think the bigger risk at the moment is deflation, which can be more punishing than rising prices because it badly distorts consumer behavior, giving shoppers an endless incentive, for instance, to put off purchases while they wait for prices to drop.

Consumers often imagine inflation to be more pronounced than it really is, especially if gasoline, the most visibly priced of all consumer products, is getting more expensive. That was the case earlier this year, when gas prices came close to $4 per gallon. But even then, inflation never got above 3 percent on an annual basis. And now that gas prices have fallen back to about $3.30, overall inflation has dropped as well.

There are still a few things getting more expensive, most notably food. That's largely because of the summer drought that hit the American farm belt, cutting into harvests and reducing the supply of some foodstuffs. Forecasting firm IHS Global Insight notes that the price of a Thanksgiving turkey was about five percent higher this year than last. And higher food prices will probably persist into 2013.

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Sheets of $20 bills are seen rolling from one printing press to another on July 12, 2012, at the U.S. Bureau of Engraving in Washington, D.C.

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There are two other things that routinely get more expensive: Healthcare and a college education. But many things routinely get cheaper, especially electronics such as TVs, computers, smartphones and music players. Low-cost Asian manufacturing has lowered the price of many household goods, including clothing, furniture and appliances. And of course the cost of housing has plummeted since the real estate bubble burst in 2006, with home affordability now close to record levels.

There's still a chance that the Fed's monetary policies could lead to higher inflation in the future, because among other things, the central bank has essentially been printing money in order to buy trillions of dollars worth of bonds and take them off the market. This "quantitative easing" is meant to boost stock prices and push down interest rates, which it has done. The question now is whether that extra money will start to push inflation beyond levels considered healthy for the economy.

The Fed insists it can keep inflation under control, because it's not literally printing paper money and flushing it into the economy, where it can't rein it back in. Instead, the Fed is creating money electronically, and so far, most of that has remained at the central bank itself, in accounts belonging to large institutions that sell securities to the Fed.

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Banks could choose to start drawing down those reserves, and lending the money to borrowers, which would increase the amount of money in circulation. That could create the sort of credit bubble that Fed critics see leading to runaway inflation. But the Fed could also counter that by paying banks more money to keep their reserves at the Fed than they'd earn by lending it out. Since the Fed has never embarked on the kind of quantitative easing it's doing now, there's no way of knowing what will happen if inflationary pressures intensify.

There's also the possibility the Fed could deliberately push inflation higher, even if it denied doing so publicly. A few prominent economists—such as Harvard's Kenneth Rogoff, a confidante of Fed Chairman Ben Bernanke—have urged the Fed to do just that, because it's a time-tested way of accelerating the paydown of onerous levels of debt, such as the U.S. government is saddled with now. Higher inflation allows a borrower to pay off debt faster, because the value of debt, which is fixed in past dollars, declines as the dollar depreciates. The side effects of "monetizing the debt," however, include higher prices for most goods and higher interest rates, which can severely punish ordinary consumers if wages don't rise by at least as much as inflation.

There are two other reasons the Fed might not want to pursue higher inflation as a debt-fighting tool. First, higher inflation would force the Fed to abandon its target of an unemployment rate below 6.5 percent, a new guideline the Fed set recently, in a major policy shift. Undermining its own policy would represent a huge loss of credibility for the Fed. Second, coming reforms meant to make entitlement programs more affordable could include a new way of measuring the cost-of-living increase Social Security recipients get every year, essentially lowering the annual multiplier. If that happened, and the Fed pushed inflation up, it could punish seniors and provoke widespread outrage.

Meanwhile, most economists think there's no serious threat of inflation now, because wages are barely rising and an oversupply of labor suggests there won't be wage inflation any time soon. Prices of non-food commodities such as energy, metals, and cotton are also soft, due to the global economic slowdown and weak demand. Since wages and material costs largely determine the price of finished products, it's hard to see what would drive up prices over the next few years. IHS, for example, predicts that inflation will remain around 2 percent all the way through 2020.

If it ends up higher than that, inflation hawks will surely holler, I told you so. But they've been telling us so for several years already, and being right once in a while doesn't validate being wrong most of the time.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success. Follow him on Twitter: @rickjnewman.