Tuesday, January 12, 2010

Fear of Inflation

With unemployment continuing its remorseless rise in the US and the recession being the deepest since the Great Depression, it hardly seems credible to start fearing inflation. Yet, some commentators argue that the threat of inflation is just around the corner. In particular, they point to an explosion of the monetary base.

Monetary Base Growth in the US

via: G.Mankiw

The monetary base is a narrow definition of the money supply. It includes notes and coins in circulation and commercial bank reserves at the Central Bank.

The monetary base is sometimes called high-powered money because a change in the monetary base can cause a large change in the money supply due to the money multiplier effect.

In normal circumstances a rapid increase in the monetary base such as we see above would be inflationary. However, these are not normal circumstances.

  • In US the Federal Reserve is paying interest on these reserves. This encourages commercial banks to hold onto these reserves and not lend them out.
  • The economic climate is discouraging lending.
  • Banks are trying to rebuild their damaged balance sheets. If anything, banks saying lending will struggle to be regained.
  • The link between money supply and inflation is complex, depending on changes in velocity of circulation. As I mentioned a year ago - link between money supply and inflation
Another fear for inflation is the rise in government borrowing 'financed' by quantitative easing. But, I still don't think the deficit will have to be inflated away.

At the moment, there is alot of spare capacity in the economy. It would take a long time for the economy to reach bottle necks were firms can push up prices.

Expectations for inflation are low. Consumers fear unemployment and continued recession, not inflation at moment.

Inflation could be a problem in the future. If Central banks keep a loose monetary policy well into the recovery, inflationary pressures could re-emerge, but this is a future concern rather than an immediate pressing concern.


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