Inflation or deflation?

The combination of a double digit fiscal deficit with Quantitative Easing by the Federal Reserve Board, i.e. printing money is potentially inflationary. A few die-hard monetarists are already forecasting a surge in inflation within the next 18 months, while many economists are concerned about the long-term risks. So is the economy going to bring us deflation or is the government going to create inflation?


Inflation arises in three possible ways. First, there is the danger of an overheating economy, when the economy is operating at full capacity and unemployment is low, so wages and prices are bid up by shortages. Fortunately, or more likely unfortunately, this scenario is years away and, if we get anywhere close to it in a hurry the Fed will be raising rates to head it off. Our expectation, however, is for a sluggish economic recovery, with no risk of an overheating economy.


The second way inflation develops is when investors lose faith in the country’s economic policy, particularly fiscal policy, leading to a collapse in the exchange rate, driving imported inflation. But we believe US policy-makers will recognize the limitation on fiscal policy (as the UK government has already been forced to do) and not allow a currency crisis to develop. There is another problem with the dollar collapse scenario. What is it going to collapse against? If the US economy is weak, Europe will be weak and indeed much of the rest of the world too. So, unless the US economy and policy balance looks a lot worse than other countries, the US dollar can certainly weaken but looks unlikely to collapse.


The third route to inflation is when an economy becomes locked into a wage-price spiral, despite a weak economy, as happened in the 1970s. But in that era unions were strong and wage contracts were frequently indexed to inflation. At times, too, there were formal prices and incomes policies which locked wages and prices together in a rising spiral. But in the modern globalised world, international competition is intense and unions are weak. A wage-price spiral therefore looks unlikely unless protectionism becomes much more of a problem than we expect.


All in all then, it is not easy to see the mechanism for inflation to take off again. Of course monetarists argue that all the quantitative easing will inevitably feed into higher spending and higher asset prices. Let us hope that they are right and it does indeed cause the economy to recover. But this will not necessarily unleash inflation, rather it will help the recovery to get underway as business responds by increasing sales and boosting capacity. Moreover, even if inflation does start to pick up again in 2010-11 it will be from a low level. The Fed will have plenty of time to respond by raising interest rates before inflation gets out of hand.


So, rather than worry about inflation moving back up to 3% or higher, the greater risk is almost certainly deflation. Past experience suggests that inflation finally bottoms some 2-4 years after the economy starts to recover . This is because, although output is rising again there is still plenty of slack in the economy. Unless we enjoy a very robust economic upturn in the next couple of years, the pattern is likely to be repeated. Thus sometime in 2011-12 we should expect a major deflation scare. We saw something similar in 2003 (almost two years after the recovery started from the 2001 recession). Then, the core inflation rate dipped to about 1% and US 10 year yields fell to 3.1%. This time, the risk is that we see outright deflation.