INFLATION IS LOOMING ON AMERICA'S HORIZON

April 21, 2009

The unprecedented explosion of the U.S. fiscal deficit raises the threat of high future inflation, says Martin Feldstein, professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research.

According to the Congressional Budget Office:

  • The president's budget implies a fiscal deficit of 13 percent of gross domestic product (GDP) in 2009 and nearly 10 percent in 2010.
  • Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 percent in the next 10 years.

The key fact is that inflation rises when demand exceeds supply, explains Feldstein:

  • A fiscal deficit raises demand when the government increases its purchase of goods and services or, by lowering taxes, induces households to increase their spending.
  • Whether this larger fiscal deficit leads to an increase in prices depends on monetary conditions.
  • If the fiscal deficit is not accompanied by an increase in the money supply, the fiscal stimulus will raise short-term interest rates, blocking the increase in demand and preventing a sustained rise in inflation.
  • So the potential inflationary danger is that the large fiscal deficit will lead to an increase in the supply of money.

This inevitably happens in developing countries that do not have the ability to issue interest-bearing debt and must therefore finance their deficits by printing money.  In contrast, when deficits don't lead to an increased supply of money, the evidence shows that they do not cause sustained price increases.

A primary example of this was the sharp fall in inflation in the early 1980s.  Inflation fell because the Federal Reserve tightened monetary conditions and allowed short-term interest rates to rise sharply, says Feldstein.

But now the large U.S. fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth, say Feldstein.

Source: Martin Feldstein, "Inflation is looming on America's horizon," Financial Times, April 19, 2009.

For text:

http://www.ft.com/cms/s/0/ae436dbc-2d09-11de-8710-00144feabdc0.html

 

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