Inflation Isn't Inevitable

The numbers are sobering. Over the past year, the level of bank reserves has soared more than tenfold, to $830 billion, and the total amount of credit the Fed has extended to the economy has doubled, to more than $1.6 trillion. Furthermore, the government is projecting that this year's fiscal deficit will top $1 trillion, the highest level relative to gross domestic product since World War II.

For anyone who has studied monetary theory, those numbers sound ominous. There's no doubt that inflation is caused by too much money chasing too few goods, and the Fed has certainly created a ton of money.

But look more closely and you'll find that the situation isn't as dire as it seems. Monetary theory teaches that inflation is caused not only by an increase in the supply of money, but also by an increase in the supply of money that overwhelms demand. The financial crisis, however, has led to unprecedented demand on the part of banks to pump up their reserves. As long as the Fed is responding to demand, an increase in the money supply is not inflationary.

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Plus, when we examine the changes in the amount of money in circulation, the numbers are much less daunting. The actual amount of currency outstanding -- those Federal Reserve notes that we all carry in our wallets -- has increased by only 7% over the past year. And M2, a measure of the money supply that includes bank deposits as well as money-market mutual funds, has increased by 11%. Much of that came after the Treasury and the Federal Deposit Insurance Corp. guaranteed assets in money-market funds last September and expanded deposit-insurance limits for banks. Bottom line: The Fed's massive infusion of money was a response to the tremendous increase in demand for liquidity by both banks and the public.

Warning signals. Although deflation is in the headlines today, the Fed has to be alert to inflationary pressures in the future. The value of the dollar, the price of gold and, most important, commodity prices have historically been early signals of inflationary pressures. Commodity prices -- particularly oil prices -- are depressed now due to the worldwide recession. But traders expect the price of oil to top $60 a barrel by the end of 2010. So once confidence returns, the Fed must act to withdraw excess liquidity and raise interest rates.

Those large projected federal deficits are manageable for now. As the economy recovers, they should be reduced by increasing tax revenues and the winding down of support programs, such as unemployment insurance. The federal government's debt-to-GDP ratio is now about 70%, not much different than the postÐWorld War II average.

Japan offers a good example of how much debt a developed country can handle without succumbing to inflation. Over the past ten years, Japan has doubled its debt-to-GDP ratio, to 180%, more than twice the average of other developed countries. Nevertheless, by reining in its money supply, Japan has not only avoided inflation but has actually experienced deflation. And the Japanese yen has been the world's strongest currency over the past decade.

Stable prices. All this doesn't mean that reckless government spending can't cause inflation. With Zimbabwe's President Robert Mugabe printing money to pay his supporters, there's no doubt that such spending is the cause of his country's spectacular hyperinflation.

Nevertheless, although President Obama's stimulus package greatly increases the near-term deficit, the data indicate that developed countries with responsible monetary authorities can accommodate liquidity shocks and absorb debt without yielding to inflation. Current policies won't spark inflation as long as policymakers keep their sights firmly fixed on their stated long-term goal of price stability.