Is Inflation Controllable?
by Warren Coats
Issue 131 - May 5, 2009

In reaction to the financial and credit crisis that seized American and international financial markets last September, the Federal Reserve has pumped enormous quantities of credit into the market in an effort to unblock clogged credit flows. The Fed creates this credit out of thin air, or as Fed Chairman Bernanke put it, it is printing money. Knowing that inflation is ultimately the result of the central bank (the Federal Reserve) printing too much money, many people are concerned that the Federal Reserve’s recent and current policies doom the U.S. and the dollar to serious inflation in the next few years.

Inflation (which is the rate of change or growth rate of the price level) reflects the growth rate of the money supply. Hence inflation is determined by the economy’s real economic growth rate and the growth rate of the money supply . If the economy is growing at 3% per year and the money supply is growing at 5% per year, inflation will be approximately 2% per year. However, historical evidence reveals a lag of one to two year between changes in money growth rates and inflation. If money growth increases to say 10%, the impact on inflation would not materialize for another one to two years.

Instead of the demand for money formulation, the quantity theory of money is sometime presented in term of money’s velocity of circulation . The key point is that with a lag of a year or two increases in the rate of growth of the money supply cause a comparable increase in inflation.

These are long run relationships. In the short run other factors can dominate the behavior of inflation. In the long run a reduction in the economy’s growth rate increases the inflation rate resulting from a given rate of growth of the money supply. However, in the short run if real income growth slows or even falls (with no change in its long run potential growth rate) it has the opposite effect on inflation. Economists refer to this as the output gap. When actual output falls below its potential, as occurs during recessions, inflation is reduced for a given rate of growth in the money supply.

Our central bank - the system of Federal Reserve Banks - indirectly controls the money supply (currency held by the public and the public’s deposits with banks) and its rate of growth. There is a link between the money created by the Fed (called base money) and the broader money supply (M). The two are related by the so called “money multiplier.” Usually the money supply grows at about the same rate as base money.

With these ideas in mind the huge injection of liquidity by the Fed is worrying many people. The Fed has increased base money as a result of large loans to banks and other financial institutions and as the result of buying government securities and mortgage back ed securities from the market. By two measures the increase has been huge. Total Federal Reserve Credit has more than doubled over the last year from 0.90 trillion dollars on April 11, 2008 to 2.15 trillion on April 15, this year. Almost all of that increase occurred since September. As a result, base money almost doubled over the same period, rising from 874 billion Sept 10, 2008 to 1,726 billion March 25 th of this year.

The Federal Reserve argues that this will not cause inflation for two reasons. First, the large increase in the provision of Federal Reserve Credit and base money was undertaken because of a large increase in the demand for liquidity by banks and other financial institutions in response to the subprime mortgage crisis. Thus doubling base money has not increased the money supply by nearly as much. Using a popular, relatively broad definition of money (MZM), the money supply rose from 8.6 trillion on April 7 2008 to 9.4 trillion on April 6, 2009. Stated in terms of growth rates, which can be directly related to inflation rates, the growth in MZM over the past year (year on year) was 9.7%. This is already significantly reduced from the year on year increase of 14.5% on January 19 th of this year and only modestly above the 8.7% average annual rate of growth over the decade ending December 2008 during which inflation averaged 3.0% (while demand for money increased 2%).

Secondly, the Fed estimates that over the past year the public’s demand for money has increased temporarily as the public “moved to safety” in the holding of its assets (currency and insured bank deposits). An increase in money demand (k) or equivalently a decrease in its velocity of circulation (V) means that the supply of money can grow more rapidly to that extent without increasing inflation. In addition, the recession with its increasing “output gap” further reducing inflation (temporarily).

Finally, the Fed intends to withdraw the extra liquidity it has injected (and thus reduce base money) as the credit crunch eases and the economy begins to recover. It remains committed to its target for inflation of around 2%. Thus the answer to the question of whether Fed policy will produce inflation in a year or two depends primarily on whether it successfully withdraws the large amounts of liquidity injected over the past six months. I have faith it will do so more or less (if not exactly) on time.

The real risk of inflation, however, is political. The Federal budget has unfunded liabilities (the difference between the cost of the benefits promised and the revenue now legislated to pay for them) that simply cannot be paid for. The Federal budget deficit expected over the next three or four years as a result of the financial crisis, recession and foreign wars of several trillion dollars is nothing compared to the present value of the government’s unfunded obligations to pay out Social Security benefits of about 13 trillion dollars. The present value of unfunded liabilities of Medicare commitments’ is six time (yes six times) that. It is not possible to raise taxes enough to cover these commitments. Promised benefits will have to be cut. Invariably tax rates will be raised as well and the slowing of economic growth resulting from all this will make the burden of these deficits even harder to carry. In addition, the rest of the world will not continue to finance as much of our annual deficits (and thus to own as much of the outstanding debt) as they have in the past, i.e. the market will force our external trade deficits to contract.

All of this adds up to higher, potentially significantly higher, interest rates in the years ahead (once we have recovered from the current recession) to enable the government to raise the money needed (sell its bonds) to finance its revenue shortfalls. Just how high interest rates will raise will depend on how much government spending can be cut and future entitlement promises reduced, how efficient and productive the economy will be and thus how high its growth rate will be, and how large a trade deficit the rest of the world lets us have.

As the President of the Federal Reserve Bank of Dallas, Richard W. Fisher, has said: “Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, noninflationary growth. The even more disturbing dark and dirty secret about deficits—especially when they careen out of control—is that they create political pressure on central bankers to adopt looser monetary policy down the road.” The short run effect of monetary growth is the opposite of its long run effect. Increasing the Fed’s creation of money initially pushes down interest rates as it buys more government securities or increases its lending to banks. However, as the higher money growth rate increases inflation, higher expected inflation gets build into new borrowing and lending interest rates pushing rates up eventually.

Current monetary policy does not need to result in higher inflation down the road. But the higher interest rates we are in for risk generating misguided political pressure on the Fed to try to keep them low. If the Federal Reserve gives in to the pressure, inflation will be higher and as soon as the economy comes to expect that higher inflation nominal interest rates will end up being even higher still. Try to remember the inflation and high interest rates of the 1970s through 1981 and tell your congressman to resist the inflation solution.

Warren Coats is a former economist with the International Monetary Fund and an international finance consultant.