Inflation, Still Not Taking Off Anytime Soon

A few years ago, amid exceptionally large federal budget deficit and extraordinarily accommodative Fed policy, a number of pundits warned of impending hyperinflation. Instead, inflation has stayed low. That hasn’t stopped the inflation worrywarts. It’s just a matter of time, they say. Inflation “has to show up at some point.” That’s not an argument. There are a number of reasons to expect inflation to stay low.

Inflation is a rise in the general level of prices over time. Hyperinflation is very high inflation. There are dozens of examples throughout history (from Angola to Zimbabwe). At its peak in November 2008, inflation in Zimbabwe averaged nearly 100% per day. As with any high inflation, hyperinflation is caused by excessive growth in the money supply (that is money growing much more rapidly than the growth in goods and services). However, it’s not just money growth that matters. The velocity, or “turnover” of money in the economy is also a key factor. More often than not, hyperinflations are associated with governments printing money to fund their deficits.

Isn’t that what’s going on in the U.S. now? No. The federal government has been borrowing a lot more in recent years and the Federal Reserve has been buying large amounts of that, but these are separate decisions. The government debt that the Fed buys doesn’t go away. Treasury still has to make good on the debt. However, the Fed typically returns some of the interest it earns to the Treasury each year, $88.9 billion just last week.

Many people are upset that the Fed can create money out of thin air. However, the Fed does this all the time in regulating the money supply. The Fed doesn’t actually print money. It simply buys Treasuries and credits the account of the seller, adding to bank reserves, which the banks can then lend out. The banks are the ones effectively “creating” money. Monetary policy works through its influence on loan growth.

The increase in the size of the Fed’s balance sheet has generated concerns, even among some senior Fed officials, about the ability to unwind its accommodation when appropriate. However, the Fed has spent a lot of time and effort working out its exit strategies. The Fed can drain reserves by raising the interest rate it pays on bank reserves held at the Fed. It can do reverse repos, lending out securities on a short-term bases. Worst case, the Fed can sell securities out of its portfolio. However, most likely, the Fed will simply let most of these securities mature over time.

Large federal budget deficits do not cause higher inflation. As a percentage of Gross Domestic Product, deficits were very large in the 1980s, but the inflation rate trended lower over the course of the decade.

Inflation is always a monetary phenomenon, but it will show up through pressure in resource markets. In capital, there are currently no signs of bottleneck or production constraints. Firms are not struggling to keep up with demand. In raw materials, there may be some long-term pressures from strong growth in emerging economies, but prices of industrial supplies and materials has been relatively mild over the last year. Moreover, it generally takes a very large increase in the prices of raw materials to have much of an impact at the consumer level (the exception is energy). In labor, the large degree of slack should limit wage pressures for the foreseeable future.

While the output gap (the difference between actual and potential economic activity) is a key driver of inflation, the Federal Reserve also pays close attention to inflation expectations, which act as inflationary inertia. Expectations of higher inflation may become self-fulfilling. In the Great Inflation of the 1970s and early 1980s, oil price shocks boosted inflation expectations, which quickly fed into the labor market. The Volcker-led Fed engineered a painful recession in the early 1980s to wring inflation expectations out of the system, but inflation expectations still remained somewhat elevated, declining only gradually over time. Inflation expectations can be observed through surveys of consumers and professional forecasters or through market measures, such as the spread between inflation-adjusted and fixed-rate Treasuries.

At the December 11-12 policy meeting the Federal Open Market Committee suggested a higher tolerance for inflation. Specifically, in its move to quantitative thresholds, the FOMC said that the federal funds rate would remain exceptionally low at least as long as the unemployment rate remains above 6.5%, the outlook for inflation one to two years out remains below 2.5%, and inflation expectations remain well anchored. However, in their projections for the next few years, senior Fed officials continue to expect inflation to trend at or below the 2% target rate. Fed Chairman Bernanke said that the 2.5% inflation threshold is “a kind of protection against any problem with price stability,” but he added that inflation should stay around 2%.

So what about the $1 trillion platinum coin, which has been posited as a workaround for the federal debt ceiling? Treasury can issue commemorative coins. It could issue a $1 trillion coin and then deposit that at the Fed and be able to pay its bills against with account. Wouldn’t that be inflationary? No. It’s no different that the Treasury issuing securities and having the Fed buy them. It would be a silly alternative to raising the debt ceiling, but less absurd than defaulting on the debt. Most likely, the possibility of the $1 trillion coin will be used as a bargaining chip in debt ceiling negotiations.

© Raymond James

© Raymond James

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