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There are two ways to think about inflation in today's economy. The first, suggested by conventional macroeconomic frameworks for the United States, is that, with rising unemployment and actual output sinking further below "potential" output, inflation will stay low—and we could actually experience the dangers of falling wages and prices (think what happens to mortgage defaults in that scenario). This is the view, for example, expressed by Fed Vice Chair Don Kohn last week, and the Obama administration seems to be on exactly the same page—talking already about a further very large fiscal stimulus.
Some people in this camp do see a danger of inflation, down the road, as the economy recovers—and resumes its potential level (or growth rate). As a result, many of them stress that the Fed will need to start "withdrawing" its support for credit and raising interest rates as soon as the economy turns the corner. One informed insider's reaction to our piece on Ben Bernanke in the Washington Post on Sunday was that we were too easy on Bernanke for failing to tighten monetary conditions as the economy began to recover after the last big easing earlier this decade (specifically, our correspondent argues that Bernanke provided the intellectual underpinnings for what Greenspan wanted to do).
In today's post-G-20 summit situation, some of my former IMF colleagues are worried that further monetary easing around the world will create inflationary pressure in middle-income emerging markets, where inflation is often harder to control than in richer "industrial countries." But if you think the broader political and economic dynamics of the United States have become more like those of emerging markets, e.g., the concentrated power of the financial elite and their ability to access corporate welfare, doesn't that also have potential implications for inflation?
In discussions of emerging markets, you rarely hear discussion of "potential output." This is a slippery concept even for the United States, with origins in the idea of running factories at "full capacity" but also reflecting the traditional bargaining power of labor. Macroeconomists argue about the exact reasoning, but most agree it's a magical place where inflation is stable. If output (or growth) is too high relative to potential, inflation rises and, depending on where you are relatively to some sort of inflation goal, the central bank needs to tighten monetary policy in order to bring it down.
Emerging markets traditionally experience big movements in relative prices (e.g., entire sectors collapse), big ups and downs in credit (i.e., regular banking crises and recoveries), and waves of government bad behavior (think expropriation of people's pensions or other assets). Potential output simply isn't stable, or perhaps even measurable, in situations with a lot of investment (in good times) and much disinvestment or scrapping of capital (when times turn sour).
So what determines inflation in emerging markets? This is simple, but also very hard to manage: the balance of supply and demand for money. The government issues money through its financing of budget deficits and various credit-support operations; this obviously tends to push up inflation (i.e., more money tends to reduce the value of money outstanding). People's demand for money depends on what they expect in terms of inflation, and this is often affected by what the exchange rate is doing—a depreciating currency both raises the prices of imports directly and moves people's inflation expectations upwards. In the background, of course, a growing economy has an increasing demand for money, so the economy can handle—and perhaps even needs—money issue. In practice, policymakers watch the inflation rate like a hawk and move rates up or down accordingly—but subject to the political pressures coming from higher or lower growth, perhaps relative to their perception of "trend" but without reference to any kind of "potential" concept.
What kind of economy is the United States today? The financial sector has taken a huge hit and is almost certainly going to contract. The credit system remains disrupted and levels of investment are almost certainly down across the board. Many firms, nonprofits, and consumers overexpanded relative to what they now see as their more permanent prospects, so there is a big move to "repair balance sheets" (pay down debt; invest less). Potential output, if that is still a meaningful concept for the United States, must be falling; and potential growth (based on some idea of where productivity can go) must also be down.
Even more important in the short run, inflation expectations are on the move. There are different ways to think about this (naturally elusive) concept, but take a look at the latest data from the inflation swap market (we'll do an explainer on this; for now, just look at how expectations have rebounded already from their low at the end of last year; if you want technicalities on this market, try the beginning of this document). If you prefer to focus on the implied inflation expectation in indexed 10-year US Treasury bonds, this stood at 1.4 percent on Friday and shows a similar rebound over the past few months. (For some reason, my official colleagues prefer bonds; my financial market friends prefer swaps.)
As we explained in our Washington Post article on April 5, we strongly support what Ben Bernanke is doing—there is a lot of uncertainty and the alternatives are much worse. But we don't accept the premise that the Fed's actions today cannot cause inflation quite so soon. Arguing more about this, here and elsewhere, should help us think about how to manage the consequences and minimize the costs.
Excessive inflation is a typical outcome in oligarchic situations when a weak (or pliant) government is unable to force the most powerful to take their losses—high inflation is, in many ways, an inefficient and regressive tax, but it's also often a transfer from poor to rich.
Also posted on Simon Johnson's blog, Baseline Scenario.
