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Inflation Fears Are Overblown
By: Dr. Charles Lieberman
Date: 5/11/2009
One of the major objections to the government's policy initiatives is that the Fed has injected far too much liquidity into the system to restore growth, so that a surge in inflation is inevitable and a heavy price to be paid for yet more policy mismanagement. The arguments supporting this conclusion are not compelling, particularly since such an outcome is dependent on policy decisions that haven't even been made yet. To the contrary, it would be an indication of the current policy's success that worsening inflation becomes a concern.
It is surprising how often the fear of rampant inflation is expressed as a concern with regard to the Fed's liquidity injections. It is correct that the Fed's policy of quantitative easing has pushed short-term interest rates near zero and nearly eliminated the cost of overnight borrowing for banks. But liquidity does not translate directly or immediately into higher prices. (Liquidity doesn't even necessarily translate into increased borrowing.) The weak economy will not tolerate that. High unemployment, low capacity utilization, and sluggish demand places business under tremendous pressure to lower prices and operating costs. Firms simply can't raise prices easily. So there can be no easy or direct translation from increases in liquidity in the financial system to higher prices for goods and services, at least not until economic growth improves significantly.
Once demand does pick up, excess capacity and unemployment will gradually decline. In time, excess capacity will dwindle and labor will become scarce. Then, firms will be able to pass along rising costs more easily into higher prices, while workers will be able to demand higher wages rates or find more lucrative jobs with other firms. We should look forward with hope (and confidence) that such days will return and we will see this process unfold over time.
For inflation to pick up significantly also requires a major policy mistake at a future critical time. As the economy heals, the Fed will have plenty of time to remove the liquidity that was introduced to promote recovery. Expansionist policies are designed to promote recovery. It is very unclear why the Fed would leave them in place once recovery is well underway. Yet such a policy mistake is a necessary assumption to create the conditions under which inflation can rise sharply. Moreover, long-term market interest rates on Treasury bonds have risen significantly off their lows, reflecting the growing conviction that a recovery is close at hand. Such rate increases help temper the pace of recovery, as well as any inflation prospects.
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