Ben Bernanke's Great Inflation Coverup

| Thu Sep. 20, 2012 10:55 AM EDT

This is what Ben Bernanke is up against:

Federal Reserve Bank of Dallas President Richard Fisher said the central bank’s third round of bond purchases will probably fail to create jobs while risking higher inflation. “I do not see an overall argument for letting inflation rise to levels where we might scare the market,” Fisher said yesterday.

....“A sustained increase” in inflation expectations “would suggest incipient doubts about our commitment to the Bernanke doctrine of sailing on a course consistent with 2 percent long- term inflation,” Fisher said in a speech in New York.

Bernanke's problem is pretty simple here: he almost certainly wants higher inflation, but he can't say he wants higher inflation. He simply doesn't have enough support for inflation tolerance among his Fed colleagues.

Nonetheless, higher inflation would be good. The simplest way to see this is to look at interest rates. Once the Fed has reduced interest rates to zero, it can't go any further. But what if the economy is so bad that all the standard models suggest you need negative interest rates to get the economy back on track? The only answer is higher inflation. If inflation is running at 2% and interest rates are at zero, the real interest rate is -2%. If you borrow money, you're effectively being allowed to pay back less than you borrowed, which provides a big incentive to buy a house or expand your business.

But if even that's not enough, then how about inflation of 4%? As long as you promise to keep interest rates at zero, the real interest rate is now -4%. The Fed is making it almost irresistable to take out a loan and buy new stuff. And there's a virtuous circle here: businesses understand that negative borrowing rates stimulate consumption and demand, so not only is it super cheap to expand production, but they have good reason to think it will pay off as demand increases in the future.

But this all depends on tolerating higher inflation for a while, and inflation is a major hot button in American politics, as guys like Fisher demonstrate. So Bernanke has to pretend that he's still dedicated to 2% inflation even though he's probably not. This is unfortunate, since it blunts the power of his policies. If he could come right out and make it clear exactly what he's doing and how long he plans to keep it up, it could have a big impact. But he can't, and so his policy loses about half its power. All because inflation is such a boogeyman. This is the price we pay for our mindless fears.

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