Wednesday, April 22, 2009

Budget Deficits and Inflation

The US has experienced its first period of deflation for over 55 years. Retail prices recently fell 0.4%. Yet, despite strong deflationary pressure, the deepest recession since the 1930s and falling asset prices, some economists are fearful of inflationary pressure in the US.

Why Threat of Inflation in a Period of Recession?

At the moment, the US is in a protracted recession. Falling output and falling demand has put a downward pressure on prices. Therefore, even though the monetary authorities have been increasing the money supply (through quantitative easing and buying toxic loans), inflation has not appeared.

In fact, it seems a paradox that money supply (M2) is growing 15%, yet inflation is absent. This is because in a recession, the velocity of circulation falls, meaning the impact of rising money supply adjusted for velocity of circulation is low. (see: Money Supply and Inflation in US)

It is a similar situation in the UK, where the Money supply is rising quickly, but adjusted for velocity of circulation, it is not inflationary.

However, the problem will come when the economy recovers and the banks desire to resume normal lending. The velocity of circulation will rise and this will magnify the effects of the increased money supply. Due to monetary intervention in the US, the excess reserves of the banking system have ballooned from less than $3bn a year ago to more than $700bn (€536bn, £474bn) now. (source: FT)

Therefore, there is a risk that any recovery may be much more inflationary than is usual. It could prove a difficult balancing act for the Federal Reserve to remove all the excess liquidity they are creating now.

Budget Deficits.

The problem is exacerbated by the rise in government borrowing in both UK and US. US national debt as a % of GDP is likely to rise from 70% of GDP to over 80%. UK public sector debt is currently 47%, but on the worst forecasts, it could also rise close to 80% of GDP. High levels of debt could put more pressure on the government to finance the debt by increasing money supply. The recent failed gilt auction doesn't bode well.

If budget deficits are financed by selling bonds they don't have to cause inflation. In the developed world budget deficits are rarely inflationary because markets are usually willing to buy government bonds which are seen as a rock solid investment. It is mainly in developed economies where markets are reluctant to buy debt, that budget deficits can cause high inflation (e.g. like Zimbabwe) But, if markets become fearful of UK and US ability to pay back, it may become much harder to finance gilt sales increasing risk of having to resort to money supply measures.

At the moment, I think the UK and US will be able to finance their deficits without resorting to printing money. But, the markets appetite for government debt could get saturated as borrowing around the world increases.

Dealing with the excess rise in money supply may prove more difficult. However, since a weak economic recovery is forecast, inflationary pressures may prove to remain muted.

Also, it is a fair point that worrying about inflation in the deepest recession since the great depression is to get your priorities wrong. The most immediate concern is the scale of the downturn and the prospect of deflation. But, it is a tricky balance and the impact of higher borrowing, quantitative easing on future inflation is hard to predict with any confidence.

Also, we could mention that falling prices are due to a temporary effect of falling oil and food prices.


1 comment:

Baz said...

Hi T,

Great analysis. But according to this research article I stumbled upon, inflation can indeed be controlled by the Fed even when the velocity of monetary circulation picks up later by jacking up the interest rates it pays or charges on the bank excess reserves (and bear in mind that bank reserves ought to be distinguished from money):

Enjoy. Hope you had a great time in America :)