PrintEventually, the piper has to get paid. In a bold attempt to prevent the collapse of the U.S. economy and financial system in 2008, policymakers threw a great deal of money at the problem hoping for the best. To some degree it worked; the financial system has stabilized and the economy has regained its footing. But excessive spending has left an aftermath of conditions that portend unfavorably for the inflation outlook.
Towards the end of last year, the Federal Reserve and the U.S. Treasury took extraordinary measures to avert pending economic doom. Unconventional lending programs, large company bailouts, and direct purchases of mortgage and Treasury bonds helped thwart a severe liquidity crisis in the credit markets. Further, the federal government approved a $787 billion economic stimulus package to invigorate spending in the real sectors of the economy.
There is no free lunch; all of this spending had to come from somewhere. A combination of printing money and borrowing money provided the source. The monetary base (a crude measure of the U.S. money supply) has grown to approximately $1.7 trillion, more than double the level at the same time last year. Further, the U.S. government’s massive borrowings have raised the national debt and the federal budget deficit to alarming levels. The national debt now stands at a record $11.8 trillion. President Obama’s Office of Management and Budget estimates a budget deficit of $1.84 trillion in 2009. To put the deficit into perspective, the budget deficit as a percentage of GDP during the past 15 years (excluding the past two years) has hovered in the +2 to -5 percent range. The 2009 $1.84 trillion budget deficit as a percentage of GDP is an astonishing 11 percent!
The mammoth growth in the nation’s money supply combined with the government’s massive borrowings, strongly indicates that, at some point, there will be increased inflationary pressures throughout the economy. Too much money eventually converts into unwanted inflation. There is a simple equation that most economists rely on in understanding the influence that the supply of money has on the economy: MV=PQ; where M represents the money supply, V represents the velocity of money (i.e., how quickly money changes hands), P is inflation and Q is the output of the economy. Using this equation, if M increases and V stays the same, it follows that either P or Q or both rises. In a fully employed economy, Q has reached its limit (except for productivity gains) and thus increasing the money supply directly results in a rise in P, inflation.
Today, the economy is weak and sluggish and is not operating at full capacity so Q (output) has more room to grow. It follows that when we increase M in the equation, we increase Q rather than P. This is why recent increases in the money supply have not resulted in inflation. Furthermore, the recent financial/credit crisis has prompted risk averse banks to lend less and thus, build up their excess reserves. This means that banks are hoarding money which reduces the velocity (V) of money; another reason why money supply growth has not resulted in inflationary pressures.
Going forward, the worry is that as the economy recovers and gains momentum, banks will begin to lend out of their excess reserves, increasing the velocity of money which could exert extraordinary upward pressure on prices of goods and services throughout the economy. The seed has been planted—the money supply has doubled in size in just a year’s time. Inflation will almost assuredly rear its ugly head.
How much inflation will the economy ultimately experience? That depends on the Fed which, of course, has some control over the money supply. The Fed could reduce the money supply immediately and quell the fears of future inflation but it would do so at the risk of sending the economy into a deeper recession. Timing is critical; the Fed needs to take action when it deems the economy healthy enough to endure a serious tightening of monetary policy. Assuredly, the Fed needs to unwind the unprecedented lending programs and liquidity facilities it put into place during the crisis as well as sell it’s unusually large holdings of Treasury and mortgage debt. The only remaining question is—when?
The timing and the magnitude of the Fed’s unwinding of the great monetary expansion of 2008 will prove challenging. Although recent upward pressure on consumer prices (CPI) and producer prices (PPI) are modest at best, commodity prices are beginning to stir. Crude oil is about $64 per barrel today compared to a low of $34 set in 2008. Similarly, gold is threatening to cross the $1,000 barrier today compared to a 2008 low of $712. Investors are justifiably nervous about inflationary pressures in the longer term.
Whether the Fed proves to be adroit and successful in it’s unwinding of unprecedented money supply growth, it is likely that the economy will experience some dose of meaningful inflation within the next two or three years. Higher inflation also means rising interest rates (e.g., mortgage rates). Projected record high budget deficits also promise to add to the worries of future inflation and rising interest rates. Inflation and rising mortgage rates are likely to worsen housing affordability conditions over the next several years, inhibiting the momentum of a highly anticipated housing expansion.
Towards the end of last year, the Federal Reserve and the U.S. Treasury took extraordinary measures to avert pending economic doom. Unconventional lending programs, large company bailouts, and direct purchases of mortgage and Treasury bonds helped thwart a severe liquidity crisis in the credit markets. Further, the federal government approved a $787 billion economic stimulus package to invigorate spending in the real sectors of the economy.
There is no free lunch; all of this spending had to come from somewhere. A combination of printing money and borrowing money provided the source. The monetary base (a crude measure of the U.S. money supply) has grown to approximately $1.7 trillion, more than double the level at the same time last year. Further, the U.S. government’s massive borrowings have raised the national debt and the federal budget deficit to alarming levels. The national debt now stands at a record $11.8 trillion. President Obama’s Office of Management and Budget estimates a budget deficit of $1.84 trillion in 2009. To put the deficit into perspective, the budget deficit as a percentage of GDP during the past 15 years (excluding the past two years) has hovered in the +2 to -5 percent range. The 2009 $1.84 trillion budget deficit as a percentage of GDP is an astonishing 11 percent!
The mammoth growth in the nation’s money supply combined with the government’s massive borrowings, strongly indicates that, at some point, there will be increased inflationary pressures throughout the economy. Too much money eventually converts into unwanted inflation. There is a simple equation that most economists rely on in understanding the influence that the supply of money has on the economy: MV=PQ; where M represents the money supply, V represents the velocity of money (i.e., how quickly money changes hands), P is inflation and Q is the output of the economy. Using this equation, if M increases and V stays the same, it follows that either P or Q or both rises. In a fully employed economy, Q has reached its limit (except for productivity gains) and thus increasing the money supply directly results in a rise in P, inflation.
Today, the economy is weak and sluggish and is not operating at full capacity so Q (output) has more room to grow. It follows that when we increase M in the equation, we increase Q rather than P. This is why recent increases in the money supply have not resulted in inflation. Furthermore, the recent financial/credit crisis has prompted risk averse banks to lend less and thus, build up their excess reserves. This means that banks are hoarding money which reduces the velocity (V) of money; another reason why money supply growth has not resulted in inflationary pressures.
Going forward, the worry is that as the economy recovers and gains momentum, banks will begin to lend out of their excess reserves, increasing the velocity of money which could exert extraordinary upward pressure on prices of goods and services throughout the economy. The seed has been planted-the money supply has doubled in size in just a year’s time. Inflation will almost assuredly rear its ugly head.
How much inflation will the economy ultimately experience? That depends on the Fed which, of course, has some control over the money supply. The Fed could reduce the money supply immediately and quell the fears of future inflation but it would do so at the risk of sending the economy into a deeper recession. Timing is critical; the Fed needs to take action when it deems the economy healthy enough to endure a serious tightening of monetary policy. Assuredly, the Fed needs to unwind the unprecedented lending programs and liquidity facilities it put into place during the crisis as well as sell it’s unusually large holdings of Treasury and mortgage debt. The only remaining question is-when?
The timing and the magnitude of the Fed’s unwinding of the great monetary expansion of 2008 will prove challenging. Although recent upward pressure on consumer prices (CPI) and producer prices (PPI) are modest at best, commodity prices are beginning to stir. Crude oil is about $64 per barrel today compared to a low of $34 set in 2008. Similarly, gold is threatening to cross the $1,000 barrier today compared to a 2008 low of $712. Investors are justifiably nervous about inflationary pressures in the longer term.
Whether the Fed proves to be adroit and successful in it’s unwinding of unprecedented money supply growth, it is likely that the economy will experience some dose of meaningful inflation within the next two or three years. Higher inflation also means rising interest rates (e.g., mortgage rates). Projected record high budget deficits also promise to add to the worries of future inflation and rising interest rates. Inflation and rising mortgage rates are likely to worsen housing affordability conditions over the next several years, inhibiting the momentum of a highly anticipated housing expansion.
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