INFLATION: THE PHANTOM MENACE

Piyush Khurana13P098

THE ZIMBABWE/WEIMAR THING Predictions of a full-fledged hyperinflation in the US for a few years since Obama took office

Fears raised by the right side of US political spectrum, conservative economists

“The interest rate the Fed controls is nearly zero; and the enormous increase in bank reserves-caused by the Fed’s purchases of bonds and mortgages – will surely bring on severe inflation if allowed to remain…No country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has never experienced deflation. These factors are harbingers of inflation.”-Allan Meltzer, Monetary economist, Fed historian (NYT, 2009)

But was he right?

TWO AND A HALF YEARS LATER… Nearly zero interest rate, Fed continued to buy bonds & mortgages

Even more bank reserves, enormous deficit

Inflation – average 2.5% over the period

– only 1.4% discounting the volatile food and energy prices

History too suggested the same Japan in 2000 - Large deficits, rapid money growth - Depressed economy, stuck in deflation

Yet the warning sounds plausible? Trillion dollar deficits, with Fed printing lots of money, why didn’t inflation rise?

THE ANSWER: DEPRESSION ECONOMICS

Liquidity trap – zero interest rates are not low enough to induce sufficient spending to restore full employment

In a normal situation, printing money is indeed inflationary

But in a liquidity trap, the amount of money printed is irrelevant

Short circuits the process by which Fed purchases lead to a boom and perhaps inflation

MONEY, DEMAND AND INFLATION

Immaculate Inflation – the belief that printing money somehow drives up prices in a way that bypasses normal demand-supply forces

Do businesses raise prices if money supply goes up?

Do workers ask for bigger pay checks owing to credit expansion?

Printing money – drives inflation via the credit expansion set in motion leading to higher spending and higher demand

Stagflation – Supply shocks, indexed pay contracts in a depressed economy

Fed Citibank Public

Credit Reserves

T-bills

Lends

PRINTING MONEY AND INFLATIONIn the months after the fall of Lehman, the Fed made big loans to banks and other financial institutions that probably helped head off an even bigger bank run than we actually had

Fed stepped into the market for commercial paper, which businesses use for short-term funding

It wasn’t doing things that would spark off inflation.

HOW HIGH IS INFLATION ANYWAY?Consumer Price Index – cost of a basket of goods and services

Temporary blips such as oil and commodity prices lead to no big rise in underlying inflation

Core Inflation – Take food and energy out of the price index, not used for calculating cost of living adjustments for social security Supposed to measure inflation inertia

“There is not much evidence that inflation is becoming broad-based or ingrained in our economy; indeed, increases in the price of a single product—gasoline—account for the bulk of the recent increase in consumer price inflation”

- Ben Bernanke, June 2011Fluctuating Vs temporarily fixed prices, self perpetuating inflation unless there’s a big supply-demand mismatch

Inflation conspiracy theories – inflation worriers choose to not trust BLS data

Aim for a moderately higher inflation i.e core inflation of ~4%

THE CASE FOR HIGHER INFLATIONOlivier Blanchard, chief economist, IMF (Feb 2010) et al. – “Rethinking Macroeconomic Policy” suggest that Fed and ECB might have aimed for excessively low inflation for “sound” policy

Very high inflation – can impose large economic costs, discourages use of money, makes planning difficult

Somewhat higher inflation could have the following benefits:Make borrowing more attractive, this increased willingness cancelling out higher interest rate

Reduce the real value of debtDownward nominal rigidity of wages

Warnings about dangers of inflation in times of depression do not make much sense