One could argue that the outcome of the current debate about the likelihood of inflation going forward is potentially the most important economic unknown facing individuals and businesses in the near term. The financial, investment and economic choices that individuals and businesses make over the near term could be profitable or disastrous depending on how this debate is resolved.
So, what is the nature of this debate?
The Great Inflation Debate
One side of the debate argues that the U.S. economy is headed towards a highly inflationary environment as a result of the following monetary and fiscal policy actions that have been taken to combat the recent recession that was ignited by the collapse of the sub prime mortgage market:
- The Federal Reserve Board has used its traditional monetary policy tools (primarily lowering the federal funds interest rate to almost zero), and some unprecedented policy tools to provide liquidity to the financial markets to ease the credit crisis that materialized.
- The U.S. government has unleashed a torrent of spending and other fiscal stimulus measures to combat the loss of jobs and homes.
Proponents of this side of the debate adhere to the basic economic principle that inflation in the long run is determined primarily by the growth of the money supply, and to some degree by the negative effects of government budget deficits.
Others argue that the U.S. economy is simply too weak to produce the kind of growth necessary to cause inflation even with the money supply growing as it currently is. They suggest that the loss of jobs, the increasing frugality of consumers, and the decreasing availability of credit will dampen economic growth sufficiently to keep inflation in check.
Knowing which side of the debate is likely to be right requires a better understanding of the economic theory behind inflation, and whether current circumstances support that theory.
Economic Theory: From Money Growth to Inflation
According to conventional economic theory, inflation in the long run is the end result of a series of four economic actions and reactions as follows:
First, the supply of money in the economy grows by a rate that is in excess of what is needed to support the economy’s natural rate of growth. In the U.S., the growth rate of the money supply is determined solely by the actions of the Federal Reserve Board. The primary policy tool that the Fed uses to control the money supply is the setting of targets for the federal funds interest rate (i.e., the interest rate that banks charge each other on loans).
Second, economic theory postulates that growth in the money supply ultimately leads to a fall in nominal interest rates on bank loans, mortgages and other consumer credit vehicles. History supports this cause-and-effect relationship.
Third, the fall in nominal interest rates produces a drop in real interest rates in the economy (i.e., nominal interest rates less the expected inflation rate prevailing at the time). Other important economic theories suggests that there is an inverse relationship between the level of real interest rates and the level of economic activity as measured by the Gross Domestic Product (GDP). That is, when real interest rates fall dramatically, real economic activity will eventually pick up dramatically.
Fourth and finally, at some point the level of real economic activity, caused by the fall in real interest rates, will push the economy to a level of activity that is in excess of what it is structurally able to support with its normally available resources. At this point, wages will begin to increase as labor shortages arise, and prices of raw materials and other production inputs will rise as demand for them increases.
The end result of this economic sequence of events is inflation across the economy.
Which Side Of the Debate Is Correct?
To determine which side of the debate is likely to be correct, you need to first believe in the conventional economic theory of inflation. Then, you need to satisfy yourself that either the economic sequences outlined above are in place or not.
Here’s one perspective to consider:
- The most recent data on money supply growth supports the argument that it is growing at an abnormally high level. So, one can argue that the first sequence is in place.
- History is filled with concrete examples of rapid money supply growth leading to inflationary pressures in the long run. So, the second sequence of the chain is supported by economic history.
- As a result of the Fed’s recent monetary policy actions, nominal interest rates have fallen dramatically over the last couple of years. In fact, real interest rates are effectively negative at some maturity ranges. Alas, the third sequence of the chain is in place.
- However, the last sequence in this chain of economic dynamics (i.e., robust economic activity going forward) is questionable. Many economic observers believe that the economic growth that we have seen over the last few quarters is artificially supported by recent monetary and fiscal policy actions, and not sustainable growth dynamics. This sequence of the chain is so inconclusive that it could go either way. It will be the primary deciding factor in determining which side of the debate ultimately proves to be correct.
Why Does It Matter To You?
If the economy is headed towards a period of severe inflation, it matters to you a lot. Conversely, if the economy is not headed towards some sign of inflationary buildup, that matters to you as well because that likely means that economic activity is stagnating.
The ultimate outcome of this debate matters to your job situation, the value of your home, the value of your investment portfolio, the purchasing power of your money and the standing of the U.S. in the global economic and political arena.
Only time will tell which side of the debate has it right, but there is no doubt that it is a debate worth watching for all individuals and businesses in the United States.
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