Deflation is Our Biggest Worry -- Not Inflation

Many economists are worried about high inflation over the next few years. This is based on a misdiagnosis of the current economic crisis. Although the recession officially began in December 2007, until last August the damage was mostly confined to housing and finance. In August 2008, the recession spread to manufacturing, not just in the U.S. but throughout the world. What caused the sharp plunge in the economy in late 2008? The standard view is the financial crisis intensified after the failure of Lehman Brothers, after which the Fed tried but failed to prop up the economy. In my view this gets things exactly backward.

The fact that prices and output started falling in late 2008 shows that monetary policy in the second half of 2008 was far too contractionary, meaning it did not increase the money supply enough. Because the Fed didn't inject enough money, the resulting deflation made the financial crisis much worse than it would otherwise have been. Debtors found it more difficult to repay loans, because the real value of the dollar rises during a period of deflation. And because wages are "sticky" or slow to change, companies forced to sell goods at lower prices must lay off workers.

Both of these factors exacerbated the financial crisis, causing it to spread far beyond the original subprime mortgage sector. Even though the fall in prices after mid-2008 was modest, any deflation at all is harmful in an economy where wage and debt contracts factor in inflation at around two to three percent. Although the brief period of outright deflation has probably ended, we will continue to see undesirably low rates of inflation, which will keep unemployment very high until businesses can bring costs down to reflect the lower level of nominal spending.

Low rates signal deflationary policies
Many economists would dispute my assertion that monetary policy was too tight last fall, pointing to low interest rates as a sign of "easy money." In fact, periods of expansionary monetary policy such as the 1970s result in both high inflation and high interest rates. In contrast, highly deflationary monetary policies in the U.S. during the 1930s and Japan during the 1990s drove the inflation rate negative, and this led to very low interest rates. The current low interest rates in America are a sign that investors don't fear inflation, which is not a sign of easy money.

Banks kept the Fed's cash
Other economists point to the Fed's large injections of cash into the banking system as an inflationary "time bomb." But last October the Fed began a policy of paying interest on those extra bank reserves in order to keep interest rates from immediately falling to zero. Unfortunately, this caused banks to hoard the money, which is why prices have fallen over the past 12 months despite the Fed's large injections of cash.

Wall Street expects low inflation
Although many pundits on Wall Street pay lip service to the threat of high inflation, actions speak louder than words. And right now savvy investors seem to expect low inflation for the foreseeable future. A rough proxy for investor inflation expectations is the spread between indexed and conventional bond yields, which reflects the premium investors in (non-indexed) conventional bonds demand to be compensated for the risk of inflation. That spread suggests that investors currently expect inflation to be about 1.5 percent per year over five years, and slightly less than two percent per year over the next 10 years.

Higher taxes, slower growth
Because monetary policy was far too contractionary in late 2008, nominal GDP fell sharply and the government resorted to fiscal stimulus. Some economists worry that the big budget deficits will eventually be monetized, i.e. that the Fed will eventually print money to pay off the Treasury's debts. But this seems very unlikely. In recent decades most central banks in developed countries have adhered to a strict inflation-targeting agenda, and rich countries with much higher debt-to-GDP ratios than the U.S. have avoided high inflation.

If your instincts tell you that there'll be a price to pay for all this deficit spending, you're right. But it won't be high inflation; the price will be higher taxes and slower growth. And if we do slip back into deflation because the Fed prematurely tightens monetary policy, it would actually make the budget deficit much worse, and also force the government to spend even more money bailing out the banking industry.

Follow Blog War on the inflation-versus-deflation debate:

• Scott Sumner, 6/26: Deflation is Our Biggest Problem -- Not Inflation
• Lee Ohanian, 6/29: The Fed Fears Deflation More Than Inflation
• Scott Sumner, 6/30: The Fed's Monetary Policy Has Veered Off Course
• Lee Ohanian, 7/1: Fed Policy on Inflation: As Good As It Gets
• Scott Sumner, 7/2: We Need Inflation to Spur a Recovery
• Lee Ohanian, 7/3: No, Inflation is Not the Key to This Recovery