U.S. Debt: Is the Inflationary Threat Over- or Understated?
September 11, 2012
In spite of the larger Federal Reserve balance sheet and increased U.S. fiscal debt, I do not see a compelling threat of a substantial U.S. inflation problem developing within the next five years. Here are three reasons why.
Chronically Slow Real Economic Growth
It took many years for the conditions that allowed the inflation problems of the 1970s to develop. Core CPI inflation averaged 1.8% per annum in the ten years to January 1967 and was as low as that mean as late as the 12 months to April 1966. The average core CPI on-year advance during the next twenty years was 6.3%, and the peak of 13.6% happened in the year to June 1980. Coincidentally, core CPI also rose 1.8% per annum over the most recently reported five years to July 2012.
Real growth has been much slower this time than in the years just prior to the 1970s burst of inflation. During the ten years between 4Q56 and 4Q66, real GDP expanded 4.2% per annum, whereas GDP grew just 1.6% annualized over the most recent ten years including 0.6% per annum over latest five-year period. The Fed can only put high powered money into the banking system, but inflation isn’t going to develop unless banks utilize the enhanced reserves to generate a multiple growth of money that can finance real economic demand for goods and services. It happened in the earlier experience when inflation resulted but not this more recent time.
Lessons from Japan’s Experience
Japan’s financial bubble burst a little more than fifteen years before America’s, so Japan is far ahead of the U.S. on this process. Japan did not develop inflation as a result of zero interest rates, quantitative easing, and a soaring budget deficit. Nor were prices stable, however. Instead, deflation took root and that problem persists. As a percent of GDP, Japan’s debt is about three times larger than U.S. debt. The Bank of Japan’s overnight money rate target hasn’t exceeded 0.5% since September 1995, not because monetary officials wish to keep short-term rates so low forever but because their economy cannot handle higher rates and has buckled when policymakers tried to tighten. There is a parallel to the U.S. in sharply slower economic growth after Japan’s bubble burst compared to before. Real Japanese GDP climbed at a marginally faster pace than 4.0% a year in the 1980s but just 0.8% per annum over the eighteen years from 2Q94 to 2Q12.
The Nature of Rising U.S. Fiscal Debt
From the spending side, U.S. fiscal policy isn’t recklessly loose either in absolute terms or when viewed in the context of economic activity. Over the two years between the second quarters of 2010 and 2012, real inflation-adjusted government expenditures — a component of GDP — contracted by 5.4%. Among other components, consumer spending advanced 3.8%, exports climbed 12.2%, and non-residential business investment soared 18.0%. Real GDP grew 4.2% over those eight quarters. Deficit reduction has proved to be a sticky process because of deficient revenues due to prior federal tax cuts and weak growth, which has held down revenues. As a percent of GDP, the U.S. federal budget gap will be twice as large as the collective euro zone’s deficit, yet inflation is higher in Euroland than the United States. The dollar’s rise of about 26% since bottoming out at $1.6038 in July 2008 is a partial reason for this counter-intuitive fact. Weaker union power in the U.S. than Europe has been another factor.
Copyright 2012, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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