Inflation Threat: Not Now, But Soon

Almost all economists say that the weakened economy has yielded one major benefit: it has greatly lowered the threat of inflation.

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High prices for oil, gold and other commodities for the past year or so, combined with a couple trillion dollars of lending by the Federal Reserve, had led to worry about runaway inflation, which hasn't been a problem in the United States for 30 years. In August, the Consumer Price Index was up 3.8% over the prior 12 months, the highest rate since 2008.

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Federal Reserve Chairman Ben Bernanke dismisses those concerns, arguing that that the abrupt slowdown in the economy since last year will keep wages and prices from rising. As N. Gregory Mankiw, who served as President Bush's chief economic adviser, puts it: “The slack labor market has kept growth in nominal wages low, and labor represents a large fraction of a typical firm's costs. A persistent inflation problem is unlikely to develop until labor costs start rising significantly.”

Bernanke and Mankiw are right: In the near future, probably through 2012, inflation will be on the order of 1% to 2% as the economy continues to struggle and little new appears likely to challenge expectations of low inflation.

Unfortunately, the slow economy doesn’t extinguish the threat of serious and debilitating inflation -- 5 to 6 percent or more -- it merely postpones it. Depending on how the government responds to the slowdown in the coming year, the delay may actually make the coming inflation even worse.

One reason this isn’t obvious is that most of us view inflation in simple terms of the economy overheating — inflation pressure rises during fast growth and eases when growth slows. Monetarists say that the money supply is the key: Inflation comes when the Fed increases the supply of cash and credit faster than the economy is generating things to spend it on.

But neither is essential to inflation. Slow growth and rising prices in the 1970s — “stagflation” — showed that growth isn’t needed to unleash a persistent dose of inflation. Neither is an increase in the money supply. There have been instances of inflation without a growing money supply, and many cases, over the last 15 years of low interest rates, when the money supply grew at a historically fast pace without inflation.

There is another potential and potent source: debt. University of Chicago economist John H. Cochrane lays it out clearly in his paper “Inflation and Debt,” available on his personal website. Cochrane starts out by noting that inflation is really just another form of default on the government’s debt. Dollars are worth less, so the debt is devalued.

The source of the coming inflation is America’s debt problem, which, Cochrane says, is worse than even at the end of World War II because of the looming burdens of Social Security and Medicare. Since more than half of federal debt is short-term, coming due in less than three years, the government must pay out about $5 trillion in cash for maturing debt each year. Even though much of it will be rolled back into Treasuries, that giant pile of money is what will fuel inflation.

The match that will light this fuel is the realization that our government’s usual tools to deal with debt aren’t available. Poisonous politics now make it impossible to use fiscal policy to craft a sensible, long-term plan to reduce the federal debt. Monetary policy is out because conventional measures (interest rate cuts) have been exhausted and other options (bond purchases) seem ineffective.

Most people rightfully doubt that the Federal Reserve would voluntarily raise inflation as a way to ease debt. But it could be forced to do so. As long as the economy appears to be in danger of another bad recession, it is unlikely that Bernanke will raise interest rates, even in the face of surging inflation. After all, he chose not to raise rates when inflation surged past a 5% annualized rate for three months in the summer of 2008.

Remember that $5 trillion in cash? If investors are skeptical about the Fed’s ability or willingness to control inflation, then some of those trillions won’t be rolled over into new Treasuries. Fearing that the value of Treasuries will be eroded, investors will instead shift to other assets — stocks, commodities, or goods and services. As demand for these alternatives rises, prices will escalate. Meanwhile, the government will still have to find buyers for all of its debt, so it will be forced to offer higher interest rates, reinforcing the inflationary pressure.

There’s also going to be upward pressure on interest rates as investors realize that it’s no safer to park money in America than in Europe. The “flight to safety” effect helping to hold rates down in the United States will disappear.

Once inflation starts to take hold, it’s likely to spiral upward, propelled by the popular sense that government has never seemed less capable of responding effectively to economic problems.

Alas, the solutions recommended by Cochrane are those that our leaders are rejecting: big cuts to entitlements, a long-term commitment to shrink government, comprehensive tax reform that boosts revenue, and huge investments to raise productivity.

Cochrane declines to call his analysis a forecast, but I will. Unless something radical changes in politics or the economic climate, a years-long period of inflation is ahead, complicating America’s already severe economic problems.