Future U.S. Inflation

April 15, 2009

The Obama Administration and Fed have been throwing everything but the kitchen sink at the U.S. recession, and the more they escalate their policy response, the louder becomes the Greek chorus warning about future inflation.  Policymakers concede that fiscal and monetary stimulus will have to be taken away aggressively once a sustainable recovery takes root, and the Casandras say that the will and ability to do that will not materialize when the time comes.

The possibility exists of significant future inflation, but that is far from an inevitable consequence of what is being done now.  As a general guide, policymakers should fight neither yesterday’s war nor tomorrow’s battle today.  Attention must be paid to what’s happening in the present.  And the task at hand now is the worst global financial system breakdown and most severe recession since the 1930’s.  Critical policy mistakes of omission and over-reliance on market stabilizers were made in that earlier era, one of which was excessive fear of runaway deficit spending by the public sector.

Potentially excessive inflation will not develop unless the economy first overheats, that is operates above full capacity.  Right now, productive resources are substantially under-utilized, and the so-called output gap between actual output and the level of output at full employment of labor and capital is still widening.  The jobless rate likely will reach 9.0% in April on its way to double-digits, and capacity usage slumped to 69.3% in March, lowest in at least 42 years.  For manufacturing, capacity use fell by a dozen percentage points over the past year to 65.8%.  No matter how rapidly money and credit grow, core inflation is more likely to decelerate than accelerate if an already big output gap is still cresting.  So officials will be afforded an enormous lead time in which they must throw present policy levers into reverse.

U.S. consumer price inflation not surprisingly is trending downward.  The headline all-items CPI advanced 5.2% per annum in the 25 years to March 1984 and 3.0% per annum over the ensuing 25 years between March 1984 and March 2009.  Consumer price inflation averaged 2.8% over the last 20 years and 2.6% over the past ten years.  During the last twelve months, the CPI fell 0.4%, which was the biggest 12-month drop since the year to August 1955.  Core inflation had dropped to 1.8% from 2.5% last July.  Moreover, price trends are decelerating in most other economies as well, and the dollar has been resilient.  Imported inflation in not a clear and present danger.

And then there is Japan’s experience.  The same inflation fears were voiced when Japan implemented numerous huge fiscal packages in the 1990’s and then instituted a policy of aggressive quantitative monetary easing during the five years to March 2006.  The central bank key interest rate has not exceeded 0.5% since August 1995, and public debt is climbing to 200% of GDP, far beyond the U.S. situation.  Instead of inflation, Japan remains in a state of deflation.  The prelude to Japan’s present problems was not an economy chronically predisposed to falling prices.  Consumer price inflation had averaged 7.3% per annum in the 20 years to 1980 and 2.5% per annum during the 10 years to 1989.  In contrast, Japan’s CPI edged up just 0.2% per annum during the past twenty years and down 0.1% per annum over the last half of that period.

The rupture of Japan’s banking system caused by bursting real estate and equity market bubbles turned out the lights on that economy’s capacity for inflation.  Moreover, central bank interest rates fell into a trap from which they could not climb out however much Bank of Japan officials tried to encourage a return to normal levels.  Documentation exists that overly loose monetary policy conducted in otherwise healthy economic times does promote inflation as occurred in the United States during the 1970’s.  Japan’s experience suggests that the dynamics of the mechanism changes when loose monetary and fiscal policies are administered to an extremely weakened economy.  Those analysts who now cite unacceptably high U.S. inflation in the future as sufficient reason for the Treasury and Fed to desist from their present policy stances need to explain why the U.S. situation is different from Japan’s and why policymakers in Washington should dismiss the non-appearance of high Japanese inflation as a fluke without application to the current U.S. situation.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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