The Next Inflation: When, Why and So What?

By Casey B. Mulligan
Today's Economist

Casey B. Mulligan is an economics professor at the University of Chicago.

Significant inflation is on the horizon. However, this inflation will have some large benefits and, in any case, cannot be blamed on the Obama administration’s deficit spending.

Many economists and bond market commentators complain that inflation is on the horizon. One of the culprits, they say, is the large amount spent by the Obama administration on the fiscal stimulus, and potentially to be spent on health care reform. They claim that federal spending increases demand and thereby increases prices.

Even if it were true that stimulating demand would create inflation, this blame is misplaced because the fiscal stimulus has not, and health care reform will not, significantly stimulate demand. Even before the “stimulus” spending started, it was clear to me that the larger effect of the fiscal stimulus would be to reduce private demand and raise public demand, without much effect on total demand.

The recent evidence has already begun to confirm the minimal aggregate impact of the fiscal stimulus: The unemployment rate in May was nowhere near as low as what the Obama administration had claimed it would be as a result of a passing a stimulus bill.

Despite some notable exceptions — such as interwar Germany — there is little or no correlation between government spending and inflation rates. Thus, even if the stimulus law and forthcoming health care laws increased total demand, there is still no guarantee that inflation would result.

The second purported culprit is the steep increase in the quantity of money.

The red line in the chart below illustrates this perspective — it measures the monetary base (that is, the value of currency, coin and Federal Reserve deposits) in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 98 in April 1930 means that the monetary base was 98 percent of what it was in October 1929). The blue line measures the monetary base for 2008-9. Unlike 1929, the monetary base surged in October, November and December, for a cumulative increase of about 50 percent.

DESCRIPTIONSource: St. Louis Fed; Casey B. Mulligan

With a couple of caveats, such a large expansion of the monetary base should increase prices in the economy — that is, create inflation.

One caveat is that, although the monetary base surged more than six months ago, the inflation has not happened yet. Part of the reason for the weak short-run link between inflation and the monetary base is that, these days, banks seem willing to hold excess reserves at the Fed. Second, it is conceivable that the Federal Reserve could contract the monetary base before inflation resulted.

But that raises the question: Will the Federal Reserve contract the monetary base enough — and with the right timing — to prevent inflation?

Some argue that the Federal Reserve does not have the political fortitude to endure the high interest rates that would supposedly result from such a contraction. I doubt that much endurance would be required, though, because the low interest rates that were created by the base expansion were so short-lived — such would be the length of time that a monetary base contraction would raise interest rates.

“Inflation will likely be a deliberate choice to reduce the housing market’s drag on the wider economy.”

More importantly, the Federal Reserve, and bankers more generally, recognize that some inflation would alleviate, although not fully erase, some of the damage done by the housing market to the wider economy.

Specifically, inflation would raise the prices of a great many commodities, goods and services, among which would be the price of housing. Higher housing prices would pull a number of mortgages out from under water — the case when more is owed on a mortgage than the market value of the house that collateralizes it — and thereby reduce the number of foreclosures.

The positive effects of inflation are why it is unlikely that there will be enough support at the Fed for reducing the monetary base in a way that would be consistent with low inflation. The inflation we will probably see in the coming months and years will not be an accidental byproduct of big government spending, or an inability of the Federal Reserve to appreciate that money growth creates inflation.

Rather, inflation will probably be a deliberate choice to reduce the housing market’s drag on the wider economy.

Comments are no longer being accepted.

Todd Strasser June 24, 2009 · 7:50 am

As long as there is an oversupply of houses, why would prices rise, even with inflation?

kevin-toronto June 24, 2009 · 8:43 am

“Rather, inflation will likely be a deliberate choice to reduce the housing market’s drag on the wider economy.”

And to decrease the value of American debt held by China and others. The trick will be to have the dollar remain the world’s reserve currency. I think it’s a trick that can be pulled off… but those who are left holding the bag are not going to be happy about it.

Tim June 24, 2009 · 8:51 am

I agree. Inflation is the most politically palatable remedy for some of our problems. Inflation does serve as a tax on savers. I wonder how the Chinese will feel about paying this tax?

HPLeft June 24, 2009 · 8:56 am

The problem is that any inflation will crush people on fixed incomes, or those who managed to husband resources while others were squandering theirs – and instead bail out the culprits who bought into irrational exuberance in the first place.

JMP June 24, 2009 · 9:01 am

But that’s looking at M0+M1 during a period in which the entire credit system was reducing leverage.

If you charted the money supply of M0+M1+M2+M3 — which more closely relates to the total money in the economy — you would see a much more level chart, because the pieces of the money supply that only exist because of leverage shrank massively.

That shrinking money supply would create a deflationary environment, and deflation on that scale can kill the economy. Bernanke and Geithner both warned that there was serious risk of deflation, and announced that they were going to do whatever they could to avoid deflation. The way to avoid deflation is to put inflationary pressures in place, which they then did.

If the Fed plays it exactly right, they will be able to withdraw the increase in M1 supply as leverage gradually increases to more rational levels — although nowhere near the sort of leverage the economy had in early-mid 2007. More likely is that the Fed will either be pressured to pull the supply too soon, risking deflation again, or too late, after significant inflation has started to set in.

Mike June 24, 2009 · 9:15 am

“… the larger effect of the fiscal stimulus would be to reduce private demand and raise public demand, without much effect on total demand.”

As President Obama has stated, the primary goal of a Federal Health Care program would be to provide coverage to large portions of the US population who do not currently have health care. Clearly, providing coverage to more people produces an increase in demand for health services.

If Professor Mulligan would like to assert that demand will not increase, then he must specifically address why he thinks that this additional Federal spending on services that have never before been provided will not increase demand. Are we to assume that all of those unisured childdren that we’ve heard so much about will refuse to seek treatment once it is made available to them?

It would be nice, in this time of fiscal trouble and wild economic theories, to have economists demostrate some basic common sense.

Rob June 24, 2009 · 9:20 am

The real inflation rate in the US has been high for a long time. Cheap consumer goods from China kept the overall index low while housing, healthcare and education increased.

Martin June 24, 2009 · 9:22 am

This piece doesn’t go nearly far enough in describing the plus side of inflation. Anyone who earns a wage in the competitive market place should see their income rise more or less in line with inflation. Since the vast majority of people live off their current earned income, this means that the downside of inflation will be small or non-existent for most people. And anyone with a mortgage, a student loan, or credit card debt will benefit enormously because the amount of their debt in relation to their income will decline. Those who will benefit the most will be people the have debt with fixed interest rates. But even variable rate loans should become less burdensome if the debtor can pay off larger amounts of principal. Provided the govenment can get back into the black (it wasn’t that long ago…), the impact of the national debt will decline as a function of inflation. This is important: interest on the national debt is the third largest item in the federal budget, after defense and social security. As tax revenues (on rising incomes) go up, the size of the national debt in relation to revenues will shrink, and surpluses can be used to retire it.

Bill Wood, Watertown, MA 02472 June 24, 2009 · 9:27 am

The benefits from inflation which Professor Mulligan cites (e.g., bailing out underwater mortgagers) are better understood as a government sponsored transfer of wealth from savers to speculators. The broader implication in the good professor’s implicit endorsement of such a policy is the notion that moral hazard (simply understood as the notion that taking excessive risks can and should lead to devastating– and hopefully behavior altering– consequences) is not good, but bad for a stable capitalist society.

Finally, the argument presented here, like most backward looking economic analyses, completely dismisses the consequences of the possible (I would actually say probable or inevitable) decline of the US dollar as the world’s primary reserve currency. It is naive at best (and irresponsible at worst) to imagine that the US economy– and with it the US currency– are independent of the forces of a dynamic global economy.

robert June 24, 2009 · 9:37 am

this is about the worst, least insightful economic commentary i have ever seen.

Skeptical June 24, 2009 · 9:45 am

The Federal Reserve and University of Chicago economists have decided:
“Rather, inflation will likely be a deliberate choice to reduce the housing market’s drag on the wider economy.”

“inflation would raise the prices of a great many commodities, goods and services, among which would be the price of housing. Higher housing prices would pull a number of mortgages out from under water-”

Uh-oh. Here we go again.

Could someone please explain to the readers exactly how creating inflation by the Fed will benefit the average American?

Wouldn’t the wiser choice be to cap and LOWER interest rates on mortgages and credit cards?

What good is higher housing prices with such a high unemployment rate? Most Americans want to be able to stay in their homes and not be forced to sell.

With new credit and loans made unavailable by the banks, how are we going to pay for the higher prices in commodities, goods and services?.

J June 24, 2009 · 9:48 am

I’d beg to quibble with your wording – namely that “the larger effect of the fiscal stimulus [was] to reduce private demand and raise public demand, without much effect on total demand.”

No, the problem was that private demand tanked on its own and had to be replaced by public demand to rescue the economy. You make it seem as if the Obama stimulus somehow *caused* the drop in consumer spending, which seems quite preposterous – rising unemployment, collapse of the credit markets and public anxiety clearly caused the cutback on spending. Obama attempted to fill this hole with stimulus spending, a concept most of your economist colleagues agree with.

You imply that the Obama stimulus was a waste as it simply took private demand and replaced it with public demand, but government spending would only serve to *increase* private demand by creating jobs and thus injecting money into the pockets of citizens and contractors. In the end the Obama stimulus significantly increases public demand and moderately increases private demand, directly treating the symptoms of our ailing economy.

Irene Geary June 24, 2009 · 9:53 am

Although inflation may “reduce the housing market’s drag on the rest of the economy”, won’t it also drastically reduce the purchasing power of Americans, especially the poorer half? Won’t this be even worse for our standard of living than the housing crisis’ effect on the economy? It sounds to me like another attempt at a “quick fix” that will really just allow profiteering by bankers to continue on longer.

For economic democracy June 24, 2009 · 10:49 am

This is madness. Milton Friedman is alive and well, after all.

Isn’t it the ‘expertise’ of University of Chicago economists such as Milton Friedman that led to the current economic crisis?

Let’s hear from Joseph Stigler instead.

Concerned Citizen June 24, 2009 · 11:17 am

“Let’s hear from Joseph Stigler instead.”

You want a just monetary system? Listen to Mises, Rothbard, Hazlitt, Hayek.

The people who saw this coming.

Levi June 24, 2009 · 11:18 am

Isn’t inflation somewhat good news for those of us that have high levels of debt (ie. mortgage)?

Concerned Citizen June 24, 2009 · 11:36 am

“Isn’t inflation somewhat good news for those of us that have high levels of debt (ie. mortgage)?”

But it’s bad for people who saw the bubble and didn’t buy because it was a bad idea.

It’s bad for people who live within their means and don’t have any debt.

It’s bad for people on a fixed income. Such as elders and the working poor.

It’s bad for people who save.

It’s basically bad for everyone *except* people with lots of debt.

John H June 24, 2009 · 12:27 pm

It is staggeringly irresponsible to promote inflation as a good thing. The “benefit” portrayed is that people who borrow money will pay back a smaller value that what the borrowed. To think that this is either fair or sustainable is folly.

Everyone who is on a fixed income is robbed by inflation. Everyone who is saving for a house, car, education, etc. is robbed. If inflation is the plan, then there should be a tax deduction for saving money to balance the loss of value. Either that or get out of dollars FAST.

To think that such a plan is sustainable relies on the notion that lenders will continue to lend despite the borrowers intention to not pay back. Higher interest rates will be demanded to compensate for inflation. If the Fed perseveres in pumping money into the economy, there will be both high inflation and high interest rates. This shouldn’t be news, it’s not like this situation hasn’t happened before.

We were once the greatest creditors on earth, we have become the greatest debtors. Now that credit is drying up, the mob is becoming unruly.

For economic democracy June 24, 2009 · 12:31 pm

To concerned citizen-

“You want a just monetary system? Listen to Mises, Rothbard, Hazlitt, Hayek.

The people who saw this coming.”

Yes, they saw this economic crisis coming but these economists are part of the problem not the solution.

Wonks Anonymous June 24, 2009 · 1:50 pm

Wait just a minute. Are you implying that the stimulus has caused the increase in private savings?

An argument could be made for this. It is called Ricardian equivalence: the public sees deficits and increases its savings to pay for the anticipated increase in taxes/inflation fueled decrease in asset values.

I believe that a stronger argument can be made that the bursting bubble has dramatically decreased the value of consumers assets. Consumers respond to this by trying to rebuild their assets through saving.

May I propose a test? Please explain why the deficits of the past 30 years were accompanied by an historic drop in savings rates that is only now beginning to be corrected.

Just because a theory is plausible does not mean that it is correct.

DCX2 June 24, 2009 · 1:58 pm

Can anyone add any insight to JMP’s comment, about M0 + M1 vs. M0 + M1 + M2 + M3? Would this be like the Fed printing money to make up for what evaporated somewhere else?

Concerned Citizen June 24, 2009 · 4:30 pm

Reply to For economic democracy:

“Yes, they saw this economic crisis coming but these economists are part of the problem not the solution.”

Explain to me how economists of the Austrian school have a lick to do with the current situation. I’m all ea…uh… eyes.

“Inflation and credit expansion, the preferred methods of present day government openhandedness, do not add anything to the amount of resources available. They make some people more prosperous, but only to the extent that they make others poorer.” —Ludwig von Mises

K P June 24, 2009 · 10:22 pm

because of challenge a head with weak Job market, there is no pressure for companies to raise salary in line witiliyh inflation. Inflation will hurt to people spending and over all affordability including housing –

We have two options

1. Higher inflation with weaker dollar
2. lower inflation with strong dollar

Housing price in USA has to come down significant to compare to world economy (living expense) to sustain over all growth

Sundar Srinivasan June 25, 2009 · 1:11 am

Bang on the money!

It would not be surprising if there is an inflation in future – but it would not be because of Obamonomics. But we cannot expect it right away, when we are in the liquidity trap. The monetary expansion shown in the graph has just resulted in one of the many forms of zero-interest M2. And it will be there until we surge out of the liquidity trap.

At the current situation, even if the commodity prices go 10% higher than the pre-recession value, it’s OK. But one thing we have to be wary about is that this looming inflation does not irrationally increase the price of one specific commodity, say oil, and create another bubble. It’s very likely to happen.

//sunnyeves.blogspot.com

Incredulous June 25, 2009 · 10:44 am

Doesn’t anyone remember the pain and economic dislocation caused by inflation in the 70’s? The incredibly high interest rates? The recessionary effect it had on the economy since nobody could afford to borrow? The huge increase in prices for things? Salaries not keeping up because anyone who stays in the same job is locked into a smaller than inflation 3 or 4% increase? An excuse for universities (where tuition has far outpaced inflation) to further increase tuition?

This economist has no credibility if he thinks inflation is so great. I think the NYT only published the article because it seeks to take Obama off the hook for inflation before it happens. It doesn’t take a genius to equate this type of government deficit spending with inflation. There is no doubt that government borrowing on such a scale increases the cost for everyone else to borrow. Inflation will be reaped and it will be bad for us all.