The Risk Of Inflation

How close are we to seeing a bout of prolonged inflation in the US? This might seem an idle question, but it is one that has quite important consequences for the US economy in the medium term. The Federal Reserve has, over the past couple of years, undertaken a major monetary expansion to support the US financial sector. It has done so though a policy of historically low interest rates - which it has signalled will continue to 2013 - and a policy of quantitative easing - which has injected about $2.3 trn into the economy. To those of the monetarist persuasion, a roaring inflation is just around the corner.

This might not be the case. A monetary expansion might be a necessary condition for an inflation, but it is not a sufficient condition on its own. A monetary expansion also has to work with a combination of the right supply and demand conditions to produce an inflation. For us, the key question is whether or not those conditions prevail at the moment. There is no doubt that prices are rising on the supply side. In particular, food prices, heating costs, and transportation costs are pushing up prices on the supply side. And yet this cost push is not igniting the flames of an inflation on the demand side. Rather than seek higher wage settlements, consumers are accepting a reduction in their living standards instead. This is because a sluggish economy has had the effect of dampening down demand for goods and services. Companies are absorbing rising input costs for fear that end user price rises would drive away their customers.

In terms of economics, we are seeing a muted demand response to the monetary expansion owing to the size of the ‘output gap’. The output gap is the difference between what GDP currently is and what GDP could have been if the recession had not occurred. Using US Bureau of Economic Analysis figures (which are expressed in 2005 constant dollars), we estimate the output gap to be in the region of $1.5 trn. This is probably an overstatement of the gap because the recession is likely to have forced a number of economic participants out of the jobs market completely. Put another way, it implies that the US economy could grow up to about 10% this year before experiencing a profound number of inflationary pressures.

Of course, the risk of inflation might be low now, but it does remain in the medium term. Should the US economy return to anything like the trend growth path, then prices will harden and wage settlements are likely to start to creep up. We expect that the US politicians will allow inflation to take hold for a while. After all, the two ways to reduce the impact of the US Federal debt pile are economic growth and inflation. If the two are combined at the same time, then so much the better. However, it is easier to start a prairie fire than to put it out, and the prospect of an inflation being created deliberately for a short term gain may well come to be seen as politically irresponsible. For the moment, though, the risk of inflation seems to be quite low.

© The European Futures Observatory 2011