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Inflation Threats on the Horizon

Posted By William Beach On February 13, 2009 @ 9:39 am In Ongoing Priorities | Comments Disabled

Hardly any Washington policymaker is worrying about inflation right now. Who blames them? The economy continues to contract; prices are falling, not rising; and, President Barack Obama speaks about years, not months, before things are better. Inflation seems about as remote right now as, well, a good return on your stock investments.

This inattention to future inflation is unfortunate: there are mounting signs that the big bugaboo of the 1970s might be ready for a return visit. No, I’m not seeing rising prices; but I am seeing the foundations of inflation in a dramatic expansion of the sources of money and credit. So, what’s up?
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In the very center of contemporary macroeconomics is the view that dramatic growth in the supply of money and credit may likely lead to sharp increases in relative prices or to inflation. The economics go like this. When the Federal Reserve increases the supplies of money and credit above normal levels through lowering key bank interest rates, by expanding its own balance sheet to provide member banks more credit, or by simply printing more money; it changes the ratio between savings and consumption. More money is spent today than otherwise would be the case. The result: prices begin to rise (and, coincidentally, the first step is taken toward a possible recession).

However, given the aggressive way the Federal Reserve has reacted to the current recession, we may have cause to worry about inflation in the near future. The Fed has dramatically and famously slashed its key interest rates to near the rarely seen 0%. It also has substantially increased the liquidity of the Reserve System through a host of other actions. Since June, the monetary base (or, basically, the reserves held by banks plus the currency part of the money supply) has increased 108 percent. That is, the monetary base has doubled in half a year. More dramatic by far has been the 19 fold increase in reserves at member banks, from $43 billion in June to $821 billion at the end of December. (see charts)

Because financial institutions are lending at very low levels now, the inflationary threat from all of these excess reserves and from growth in the monetary base is virtually zero. As long as the economy continues to slump, we’re safe from rapid price increases.
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However, economic recovery hopefully will be accompanied by increased lending. That’s the whole idea of the Bush and Obama administrations’ financial recovery programs. So, what happens if lending does recover? Given the tremendous amount of liquidity that the Fed has introduced into the financial system, prices may begin moving back up quickly. In other words, we could be in for a lot of inflation.

We could be, but that depends on what the Federal Reserve decides to do. On the one hand, the Fed could support the recovery and tolerate the growth of inflation. On the other hand, it could focus on the many terrible threats of inflation to our economy’s future and squeeze the liquidity down to stable levels. That decision would cause the economy to slow and might stymie recovery.


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