“Measures of underlying inflation are currently at levels somewhat below those the committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability.” The Federal Reserve Board, September 22, 2010.
Dangerous words such as these must be interpreted with caution, against the background of existing economic conditions, as interpreted from relevant economic theory. Let me explain.
The United States economy, at this point in time does not confront any significant risk of price deflation. Conventional measures of consumer and wholesale price inflation are all positive, within the 1 percent annual range and plus, as compared with the Federal Reserve’s usual goal of between 1 and 2 per cent per annum. The dollar is falling in value against all major currencies, and this places upward pressure on the dollar value of imports, injecting additional inflation into the system. Commodity prices are rising, and these will also filter into inflationary pressure, in a loose monetary environment. The monetary envionment is so loose that gold prices have surged to an historical high of $1,300 per ounce.
Recent and projected quantitative easing on the part of the Federal Reserve is not simply a process of pumping high-powered money into the economy. It is a mechanism for driving short and long-term Treasury security yields down to historic lows, without any evidence of a liquidity trap. Put bluntly, this is the road to hyper-inflation once high-powered money translates itself into leveraged money supply increases as defined by M1 or M2 criteria. Out-of-control government spending is being financed by the printing press, the classical pre- condition for such a disaster.
Let us suppose that Ben Bernanke has not lost all his little grey cells, and does not want to go down in history as ’hyper-inflation’ as well as ‘helicopter’ Ben. If we take hyper-inflation off the table, we are left with stagflation as the most likely outcome of this episode in economic policy adventurism. Let me explain in terms of the relevant economic model: Milton Friedman’s monetary theory of adaptive expectations.
According to this theory, which has not been refuted by empirical analysis, the demand for money, under near-normal times, is a stable function of several variables. The nature of the relationship is such that, over time, any additional injection of high-powered money will augment the money supply M. This augmented M will elevate V (the income velocity of circulation of money) on its route to PY (the price level times real output) on the right-hand-side of the equation. Initially, the impact may locate itself somewhat on Y (real output). With long and variable lags, however, it will impact primarily on P (the price level). The transmission route will take place through adaptive (not strictly rational) expectations driven by decreasing money illusion in the labour markets as contracts are reworked in an inflation-expectations environment.
Just as the inflationary-expectations are slow to manifest themselves, offering short-term benefits to employment as real wages fall, so they will be excruciatingly slow to retreat once (if) strong monetary medicine is applied. As real wages rise, so employment will fall. In an employment environment as bleak as the present, this process will be as painful as it will be unnecesaary.
Add to this the adverse impact of rising public expenditure and an increasing debt burden upon the rate of private investment – the crowding out hypothesis – and the lowered productivity that such increasing socialism inevitably implies, and the witches’ cauldron of stagflation will boil and it will bubble until all the poisons of the earth spill out.
Hat Tip to Maggie