Inflation's Looming Shadow
By Paul Ryan
We currently have a dangerous policy mix brewing in our country. On the fiscal side, government is spending record amounts of money that is producing sizeable deficits that add to our national debt (Figure 1) . The Treasury is issuing record amounts of debt – over $2 trillion this year alone. Unfortunately, these are not temporary trends, as projections show show sizeable budget deficits and a growing debt burden as far as the eye can see.
Meanwhile, the Fed has injected an enormous amount of monetary stimulus into the economy and is even purchasing longer-term Treasury bonds to keep borrowing rates low. This blurring of the lines between our fiscal and monetary policy gives the dangerous impression that the U.S. could one day begin to meet its fiscal obligations by simply printing money. The Fed is determined to avoid this scenario, but we still must realize that we are playing with fire.
Over the past year, the Fed has more than doubled the monetary base (Figure 2) in order to fund the broad array of programs it has used to try to ease credit conditions in our economy. Some tend to refer to this as the Fed simply “printing money,” but it is important to point out that the lion’s share of the increase in the monetary base is due to a large expansion in bank reserves. This has not caused inflationary pressure because that money is not yet circulating in the broader economy. Banks remain reluctant to lend and are riding out this wave of economic uncertainty by sitting on their cash. Likewise, many consumers and businesses have been holding onto their money and paying down debt instead of spending.
Ordinarily, very low interest rates and an increasing monetary base would tend to stimulate borrowing and spending, but the economy appears stuck in a situation that economists refer to as a “liquidity trap.” The standard monetary pumps are primed, but the release valves to the broader economy – the banks – remain clogged. As a result, the velocity, or turnover, of money in the economy has fallen sharply over the past year (Figure 3) .
This situation is particularly damaging to our engines of job creation, small businesses, which are heavily dependent on banks for credit and don’t have the diverse funding resources available to larger businesses. In fact, the small business credit crunch is a key reason why job losses have been so severe during this economic recession. Small businesses have accounted for nearly half of the 7+ million jobs lost during this recession. During the recession in 2001, which didn’t include a severe credit crunch, just 9 percent of all job losses were concentrated in small businesses.
As the economy recovers and the normal lending, borrowing and spending channels open up, the Fed will need to start draining these large bank reserves from the system or else severe price pressures will result. In short, to control inflation, the Fed will have to trigger in essence another credit crunch by pulling money out of the banking system, at the very time business lending begins to pick up. But the Fed may be too slow to act or tempted to keep its monetary policy too loose for too long, which could lead to yet another credit and asset bubble.
We are already seeing some potentially dangerous developments in financial markets. Over the past six months alone, the dollar has declined nearly 15 percent against major currencies (Figure 4) . Due to extremely low interest rates in the U.S., some investors are using the dollar as a funding currency for a carry trade (borrowing and then selling dollars to buy higher-yielding foreign assets), which is further contributing to downward pressure. A falling dollar pushes up the cost of imported goods and commodities. Gold is at an all-time high above $1,000 per troy ounce (Figure 5) , silver and copper prices are on the rise, and oil prices have doubled over the past 8 months. These commodity price increases could be an early harbinger of future inflation.
My concern about inflation is rooted in the severe economic pain it could cause. Rising prices chip away at the value of workers’ wages and savings and are particularly damaging to our seniors living on fixed incomes. If inflation gets out of hand, the Fed will be forced to hike interest rates and we could end up with the worst possible combination: rising prices, high interest rates, high unemployment and weak growth, or stagflation.
It is critical that policymakers remain ever mindful of this serious threat, get a grip on our debt crisis and make a renewed commitment to price stability.