Feldstein: The Coming Inflation

Harvard professor and former Reagan chief economic adviser has been making the rounds warning that sharp inflation threatens to choke off any economic recovery on the horizon. Here he is on Bloomberg explaining the case he made in a recent op-ed in the Financial Times. From the FT:

The US last week showed its first signs of deflation for 55 years, prompting inevitable fears of further deflation in the future. Yet the primary reason for the negative rate of US inflation is the dramatic 30 per cent fall of commodity prices. That will not happen again. Moreover, excluding food and energy, consumer prices are up 1.8 per cent from a year ago. That is the good news: the outlook for the longer term is more ominous.

This is slightly misleading. Yes, excluding food and energy, consumer prices were up 1.8% from last year, but almost all of that increase came from price increases in tobacco products due to new taxes. Deflation is still the most immediate threat to the economy. Back to the piece:

The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation. According to the Congressional Budget Office, the president’s budget implies a fiscal deficit of 13 per cent of gross domestic product in 2009 and nearly 10 per cent in 2010. Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 per cent in the next 10 years.

There is ample historic evidence of the link between fiscal profligacy and subsequent inflation. But historic evidence and economic analysis also show that the inflationary effects can be avoided if the fiscal deficits are not accompanied by a sustained increase in the money supply and, more generally, by an easing of monetary conditions.

The key fact is that inflation rises when demand exceeds supply. A fiscal deficit raises demand when the government increases its purchase of goods and services or, by lowering taxes, induces households to increase their spending. Whether this larger fiscal deficit leads to an increase in prices depends on monetary conditions. If the fiscal deficit is not accompanied by an increase in the money supply, the fiscal stimulus will raise short-term interest rates, blocking the increase in demand and preventing a sustained rise in inflation.

In short: fiscal deficits alone will not cause inflation; loose monetary policy is the key issue. As Mark Thoma and Scott Sumner recently explained, expansionary fiscal policy need not lead to the economy overheating if monetary policy counteracts it (this is why our multiplier estimates are largely questions of theory rather than empirical fact). Since the Fed normally tries to meet its inflation targets, it normally acts as such a countervailing force. In this deflationary environment, however, Bernanke & Co. have been so desperately trying to induce inflation that they risk unleashing it on a much larger scale than they want. As Feldstein explains:

But now the large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth. The broad money supply (M2) is already increasing at an annual rate of nearly 15 per cent. The excess reserves of the banking system have ballooned from less than $3bn a year ago to more than $700bn (€536bn, £474bn) now....

The deep recession means that there is no immediate risk of inflation. The aggregate demand for labour and goods and services is much less than the potential supply. But when the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.

This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.

Once the economy begins to recover - something Feldstein doesn't see happening until 2010 - banks will likely begin putting these excess reserves to work. The Fed's ability to pull back the money supply will be hampered by not only a lack of T-bills to sell, but also by the fact that so much of the collateral it has to sell are toxic assets of dubious value. From a deflationary spiral to stagflation, here we come!

Given these considerations, it is difficult to see what alternative policies Feldstein wishes Bernanke would pursue. Feldstein readily admits that the banks will be struggling to survive for the next two years, and that aggregate demand will remain weak. In this context, the Fed's massive injections of liquidity certainly seem defensible. And yet if the Fed succeeds in mitigating this downward pressure on the economy, the chances of them successfully pulling back the massive liquidity it has injected look negligible. Do we have any other options? And isn't stagflation preferrable to a deflationary spiral? At least the Fed can easily cure stagflation - pull a Volcker and raise short-term rates until the inflation is wrung out of the economy. Deflation is an altogether different beast. Whether the Fed actually can get us out of this liquidity trap and halt the downard pressure on prices is more a matter of theory than fact. We seem to only have bad and less bad choices ahead.