Deflation or Inflation?

So, the Fed is going for QE2. Fed Chairman Ben Bernanke is ready to buy more Treasury. Or at least the markets anticipate it. His concern is now deflation, not inflation.

The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve's dual mandate in the longer run. In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable. Given that monetary policy works with a lag, the more relevant question is whether this situation is forecast to continue. In light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation--setting aside the inevitable short-run volatility--will be less than the mandate-consistent inflation rate for some time. Of course, forecasts of inflation, as of other key economic variables, are uncertain and must be regularly updated with the arrival of new information.

Then, why are people suddenly worrying inflation, not deflation?

Treasury 30-year bonds tumbled, pushing yields to the biggest weekly increase since August 2009, on speculation that Federal Reserve efforts to spur the economy will reignite inflation.

The 30-year yield rose above 4 percent yesterday for the first time in two months after data showed retail sales rose more than forecast and New York area manufacturing climbed. Fed Chairman Ben S. Bernanke said additional stimulus may be warranted, in part because inflation is too low. The Fed will release its regional economic survey next week. The U.S. sold $66 billion of notes and bonds to lower-than-average demand. 

The spread of both 5- and 10-year yields between conventional and TIPS bonds has been widening since last month. Is it a proof that Bernanke has already made some success in combating deflation? Or is it the wrong time for the Fed to start QE2, thus begetting uncontrollable inflation?

My guess is that knowing rising inflation expectations shown above, Bernanke and Co. is betting on the notion that underlying inflation is "too low." The Dallas Fed once claimed that

TIIS spreads are not a very good guide to inflation expectations because they are sensitive to changes in inflation uncertainty and the demand for liquidity. In particular, the recent increase in TIIS spreads probably overstates the extent to which investors' long-term inflation expectations have risen. It should not carry much weight as evidence for the proposition that the Fed has eased too much in response to the current economic slowdown.

So, according to the Dallas Fed, TIPS spreads are not a reliable measure of inflation expectations, especially when they are rising. It seems like Bernanke counts on more conventional measures of inflation like CPI or PCEPI, which has shown meagre inflation recently.