MAY 2004

Fed May Have Misdiagnosed Deflation Risk

A fascinating new study from economists at the Federal Reserve Bank of Atlanta suggests that the Federal Reserve Board may have misinterpreted some key signals of inflationary pressures three years ago, leading it to push interest rates lower than was otherwise warranted. Recall that the Fed’s concerns were heightened when the “core” inflation rate began a downward plunge beginning in late 2001. Ongoing concerns at the lack of inflationary pressure, coupled with sluggish economic performance, prompted the central bank to embark on successive expansions of the money supply to force down interest rates, culminating in a short-term interest rate target of just 1% in June 2003, the lowest level since 1958. The target rate has been there ever since.

The new study suggests that inflationary pressures then (and now) were not as low as they appeared. According to the authors, two-thirds of the observed decline in core inflation between November 2001 and December 2003 resulted from rapid declines in used car prices and a slowing in rental rates on apartments and housing. Indeed, some of the decline in both used car prices and rental rates was triggered by the declines in interest rates. In the automobile market, manufacturers introduced 0% financing as interest rates fell. This spurred new car sales, but reduced the demand for used cars and increased the supply as buyers traded in their existing vehicles when they purchased new ones. Used car prices plummeted. Similarly, as mortgage interest rates fell sharply, many households bought new homes for the first time, reducing demand for apartments. Apartment rental rates weakened. This effect also served to hold down the inflation index measure of the cost of owner-occupied housing, which, for technical reasons, is calculated based on rents for similar housing units rather than on actual sale prices of homes.

According to the study’s authors, the Fed may have interpreted the weakening of housing and vehicle prices as a sign of fundamental weakness in consumer demand. Instead, the authors note, it was actually the by-product of the Fed’s monetary policy, at least in part, which then provided the empirical evidence for even more rate cuts. If this is true, then inflationary pressures may be greater than is currently recognized. Moreover, if the Fed starts to raise interest rates, as it may well do over the next 6 months to nip inflationary pressures, the reverse effect will occur and measured inflation will likely accelerate rapidly.

Wall Street Journal reporter Greg Ip observes that the study does not reflect the mainstream thinking within the Federal Reserve Board. However, he also notes that "it is not unprecedented for statistical quirks to throw off a central bank’s reading on inflation."