Alan Blinder on the Inflation Debate

In recent posts (e.g., this one) we noted the views of Paul Krugman, John Taylor, and others on whether the Fed's responses to the financial crisis might lead to high inflation in future. Yesterday, Alan Blinder, the Princeton economist, former Fed governor, and long-time Democratic policy adviser weighed in on the debate in his Sunday New York Times Business Section column, Economic View: "Why Inflation isn't a Danger"). Blinder's argument essentially boils down to this: The Fed is aware that if it doesn't rein in the money supply in a timely manner as the crisis abates, this will lead to inflation. The Fed has planned for this, and has the competence to pull this off. Further, bond market participants appear to support this view. Blinder wrote,

[The Fed] has committed itself to an inflation target of just under 2 percent. Of course, none of that assures us that the Fed will hit the bull’s-eye. It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.

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SKEPTICAL? Then let’s see what the bond market vigilantes really think.

The market’s implied forecast of future inflation is indicated by the difference between the nominal interest rates on regular Treasury debt and the corresponding real interest rates on Treasury Inflation Protected Securities, or TIPS. These estimates change daily. But on Friday, the five-year expected inflation rate was about 1.6 percent and the 10-year expected rate was about 1.9 percent. Notice that the latter matches the Fed’s inflation target. I don’t think that’s a coincidence.

But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.

In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.