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Did inflation delay the Fed's taper?

September 18, 2013: 2:30 PM ET

A slower rise in consumer prices might have given Ben Bernanke an easy taper escape, had he decided to take it.

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FORTUNE -- The taper is off. On Wednesday, the Federal Reserve said it would keep its bond-buying program in full force for at least another month. Many people had expected Bernanke to announce the Fed was going to pull back some portion of its bond purchases.

Why did Bernanke delay his taper plans? One potential reason: inflation, or, rather, the lack of it.

Most people think of inflation as a bad thing. But it can also be an indicator of economic activity. When demand for goods increases, prices tend to rise more quickly. Recently, though, the opposite has been happening. Consumer price increases, which had picked up two years ago as the economy was strengthening, have slowed.

According to the government's most recent data on consumer prices, released on Tuesday, inflation is running at a minuscule 1.5%. That's down from 2% a month ago, and 3.7% two years ago. And, excluding the Great Recession, inflation is near the low end of its 30-year range.  Slower price increases suggests that the economy is headed for another rough patch in what has already been a dismal recovery. That would make now a bad time for Bernanke to be pulling back on any economic stimulus.

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Of course, low inflation isn't always an indication that the economy is slowing. Inflation, for instance, dropped in 2006, at least a year before the economy ran into trouble. And inflation was running extremely low in 2010. Nevertheless, the economy continued to recover.

But back in 2010 there were a number of good reasons for low inflation. For one, bank lending had yet to thaw from the credit crunch. The amount of money flowing around the economy has a direct effect on inflation rates. But lending is bounding back. And the housing market is recovering -- another factor that affects consumer prices. So if the economy is truly improving, you would expect inflation to be picking up, or to at least be stable, not dropping.

One possible explanation for today's inflation levels: Obamacare. Recently, health care prices, which have long risen faster than inflation, have been rising at a slower pace than usual, which some attribute to health care reform. That could be dragging down inflation, even as economic activity continues to pick up. If that's the case, then the Fed has nothing to worry about when it pulls back on its stimulus.

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Low inflation could even been a boon for Bernanke. Some are worried that interest rates will soar when the Fed curtails its bond buying program. But interest rates tend to stick relatively close to inflation. The 10-year bond yield is usually within two percentage points of inflation. The spread is now around 1.3 percentage points. So, low inflation could put a cap on rates, which would be good. That would allow Bernanke to exit his bond buying program and still keep interest rates relatively low, stimulating the economy. If that's true, Bernanke and the Fed may have made the wrong call. Tapering now would have made a lot of sense.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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