Inflation or Deflation?

For the last year and a half my assessment has been that the near-term pressures on the U.S. economy were deflationary, while long-term fundamentals involve significant inflation risks. It’s time for a look at the data that have come in over the last 6 months, and time to say that I still see things exactly the same way.

The short-run deflationary forces come from the substantial underemployment of potentially productive labor and capital. I noted in January that, given the high unemployment rate at the time, a traditional Phillips Curve would predict deflation in the CPI over 2010-2011. Six months into the year, that’s about how things have unfolded so far. The Bureau of Labor Statistics reported on Thursday that the seasonally adjusted consumer price index for May was at exactly the same value it had been in December.   


6-month CPI inflation (quoted at an annual rate), 1947:M1-2010:M5. Data source: FRED

I often hear the idea expressed that all the money that the Federal Reserve has created through its various responses to to the financial crisis has to produce inflation. With the exception of the assets the Fed acquired through the AIG deal, which aren’t going anywhere, most of the other special facilities the Fed implemented in the fall of 2008 have been wound down, replaced with long-term holdings of mortgage-backed securities and agency debt.


All Federal Reserve assets, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to June 16, 2010. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility plus net portfolio holdings of TALF LLC; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III plus preferred interest in AIA Aurora LLC and ALICO Holdings LLC; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Although the Fed’s balance sheet remains expanded, the potential currency that these operations created still remains parked as excess reserves held by banks or the Treasury. It hasn’t shown up as currency in circulation, and I don’t see a reason to expect it to soon. The nation’s money supply, as measured by seasonally adjusted M1, is only up 1% since December.


Federal Reserve liabilities, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to June 16, 2010. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

The source of my concern about long-run inflation comes not from the expansion of the Fed’s balance sheet, but instead from worries about the ability of the U.S. government to fund its fiscal expenditures and debt-servicing obligations as we get another 5 or 10 years down the current path. Just as many analysts have had trouble seeing how Greece can reasonably be expected over the near term to move to primary surpluses sufficient to meet its growing debt servicing costs, I have similar problems squaring the numbers for the U.S. looking a little farther ahead.

The way that I would envision these pressures translating into inflation would be a flight from the dollar by international lenders, leading to depreciation of the exchange rate, increase in the dollar price of traded goods, and possible sharp challenges for rolling over U.S. Treasury debt. We’ve of course been seeing the exact opposite of this over the last few months, as worries in Europe and elsewhere have resulted in a flight to the dollar and the perceived safety of U.S. Treasuries. That appreciation of the dollar has been one factor keeping U.S. inflation down. So any inflation scare is clearly not an incipient development, but instead something we’d possibly face farther down the road.


Source: FRED.

Some reversal of that recent trend and resumption of dollar depreciation would in fact be quite welcome at the moment. But a loss of world confidence in the ability of Washington to honor its debts would not. I continue to believe that it is quite important for the U.S. to communicate its seriousness about bringing the long-run fiscal challenges under control. I should emphasize that, in saying this, I am definitely not among those calling for current budget cuts– that would only aggravate our immediate employment challenges. But I do think now would be an excellent time for fiscal reforms that make the long-run math look substantially more responsible. Examples include raising the eligibiity age for Social Security and Medicare, increasing the Medicare copay, budget reform to bring earmarks under control, a plan to ease the government out of responsibiity for implicitly or explicitly guaranteeing U.S. mortgage debt, and reforms at the state and local government level to bring their long-run pension liabilities under control.

America needs leaders willing to talk honestly about our long-run fiscal challenges and what needs to be done to address them.

I can dream, can’t I?

Originally published at Econbrowser and reproduced here with the author’s permission.