It’s taken for granted in some circles that a sharp acceleration of inflation is the inevitable result of the monetary and fiscal policies of the past year or so. I disagree for the following reasons.
*While budget deficits have grown dramatically, in absolute terms and as a percentage of GDP, for the most part they have not been financed with newly created money. Since late 2008 and early 2009, monetary expansion has been moderate, especially given the slack created by the recession. Money growth has been more moderate than many people assume, both M2 and M1.
As the economy recovers and the slack is taken up, if the money supply continues its recent slow growth, interest rates will be bid up to facilitate the absorption of the increased borrowing by the government without an acceleration of inflation. The government will be crowding out private spending via higher interest rates.
*It will no doubt come as a surprise to many that money growth has been moderate since its initial explosion at the end of 2008. That’s because they hear so much about the expansion of the Fed’s balance sheet, which would normally imply an expansion of bank reserves and money. Fed assets have more than doubled with virtually all the increase taking place in late 2008. The asset expansion has produced a sharp rise in bank reserves, and hence the monetary base, which is composed of bank reserves and currency outside the banking system. However, banks have not used those reserves to expand loans and investments at a rate large enough to produce rapid money expansion. Instead, banks have accumulated reserves far in excess of the amount required to back their deposit liabilities. This accumulation of “excess reserves” is no doubt the result of banker uncertainty and fear about their viability during the period of crisis. In particular, banks are remaining more liquid than regulations require to protect their remaining capital. Virtually all of the expansion in the Fed’s assets are matched by an expansion of excess reserves—excess from a regulatory standpoint, but obviously not excess to the bankers themselves since they are holding them voluntarily.
The main reason I don’t expect a breakout of inflation is the moderate growth in the money supply that has accompanied the expansion of budget deficits. Other reasons include the depth of the recession and the continued slack in the economy evidenced by the low employment growth and the low capacity utilization rate.
Other factors I expect to help hold down inflation include the downward pressure on labor costs of the rapid expansion in productivity since the middle of 2009. Productivity growth in the last three measured quarters exceeds six percent, causing unit labor costs to decline—not increase slower, but decline significantly. Lower unit labor costs are confirmed by the employment cost index.
Normally, I don’t emphasize labor cost in an analysis of inflation since I learned not to put much stock in cost-push inflation, but the recent changes are quite large and are undoubtedly a significant offset to rising commodity and other wholesale costs in firms’ pricing decisions. It is thus worth noting that there is no cost-push inflation to work against or counter the reduction of demand-pull forces that would intensify inflation.
*Some people on the other side of this argument might argue that an acceleration of inflation is inevitable because it has already started. They point to elevated oil and gold prices and to some price indexes. Some of the latter do show an increase over recent months of year-over-year inflation rates. A look at the producer price index puts that into perspective, however. The principal mitigating factor is that year-over-year increases lately have been from year-ago levels that were significantly negative. In other words, the deflation that we had earlier is being offset, leaving the two-year rate much flatter.
To summarize: I don’t expect an acceleration of inflation because money growth has been moderate despite the expansion of the Fed’s balance sheet, and also because productivity gains have reduced unit labor costs. Charts showing a recent pick-up in year over year inflation rates have very depressed rates as their base. But, then, I could be wrong.