What Ben Bernanke Will Do When the Accelerated Price Inflation Hits

Many are familiar with the Ben Bernanke book, Essays on the Great Depression, which is a compilation of writings about the Great Depression by various economists.  Fewer, however, are aware that Bernanke contributed to a work on inflation, Inflation Targeting.

This second book may provide us with important clues as to how Bernanke will act if price inflation begins to accelerate. And, indeed, it appears that some time in 2013 a perfect storm of actors may develop to push price inflation much higher.

In 2013, meat prices are very likely to climb given the drought this year which caused many farmers to deliver cattle early for slaughter, rather than pay the soaring feed prices. This will mean a smaller supply of meat available in 2013. In addition, the oil price continues to react to the possibility of war against Iran and the Iranian threat to mine the Strait of Hormuz.

In addition, to these supply side factors (which can not be considered overall price inflation), on the demand side we have Bernanke printing money again, with early indications that the money is entering the system and not simply being put aside by banks into excess reserves. Thus, this increase in money supply is very likely to fuel price inflation, especially given that their are strong indications that the overall demand to hold cash is shrinking (as evidenced by climbing housing prices and stock prices).

If all these factors intensify in 2013, the price inflation could be very strong. How will Bernanke react? Probably very slowly. Indeed, while the current stated Fed price inflation target is 2% (which is where the 12 month CPI is currently at), Bernanke's real target is likely 3%. In Inflation Targeting, we have this:

Also, many economists believe (though it remains controversial) that benefits of low inflation may be realized when inflation reaches the 2% to 3% range.

What this means is that Bernanke isn't even going to worry about price inflation for another 100 basis points, and then he is likely to dismiss the price increases coming from meat and oil prices. Inflation Targeting again:

...in all countries we have examined, the monetary policy authorities routinely allow deviations from inflation targets in response to supply shocks....For example, suppose a jump in oil prices suddenly pushed inflation from lows levels to a level above the long-run goal. In this circumstance, the inflation-targeting approach would not require an immediate draconian response....the Federal Reserve would have to explain to the public that its actions were designed to keep output and employment losses to a minimum, while still maintaining the objective of long-run price stability.

In other words, when prices start to climb because of supply factors, he will simply jawbone and not attempt to fight the increase in prices. But, what if prices are climbing not only because of  supply factors, but also because of the money printing and a decline in the desire to hold cash? This could push price inflation much higher, but only result in a modest response from Bernanke. From Inflation Targeting (my bold):

A common practice has been to distinguish between long-run inflation goal and short run targets, with the latter set to converge gradually with the former.

What about an exploding money supply, again little concern from Bernanke is likely to be the result. From Inflation Targeting:

Inflation-targeting central banks generally do not tie themselves to specific intermediate targets, such as the growth rate of the money stock...

Bottom line: The likelihood of strong price increases exist in 2013, with a very slow reaction from Bernanke. He isn't likely to be concerned about money supply growth. He will be quick to dismiss price increase as coming from the supply side (which will be partially accurate). But when prices start to climb dramatically above target, anywhere between 5% to 10% annualized increases, he is  likely to only react gradually to bring prices down. This will be a prescription for disaster, as the desire to hold cash will continue to shrink as prices climb, pushing people to spend their cash more aggressively, only a dramatic slowdown in money growth would stop the price increases at that point. And there is no indication that at such a time Bernanke will even be looking at money supply growth. In other words, a perfect storm of price inflation could hit the U.S. in 2013, including a lackadaisical response from Bernanke.