Not long ago, pundits fretted that the recession-bound economy might suffer a bout of deflation, when prices deflate and strangle nascent signs of a recovery. Now, with indications that we may have skirted that obstacle, another seemingly unrelated economic threat may lie ahead: inflation.
With manufacturers cutting production and retailers routinely marking down prices, inflation may sound like an odd concern. In fact, the average prices of goods and services in the United States will fall slightly in 2009, by 0.7%, according to Northern Trust predictions.
So why are economists keeping an eye on inflation even as prices are falling? Because inflation historically has followed closely on the heels of recession. And with a recession larger than we’ve seen since the Great Depression, people are understandably concerned about what may happen next.
Recipe for Inflation
While dramatic, inflation — a general, economy-wide increase in prices — is unlikely right now, it would not be so far-fetched in a couple of years. The reason? Experience shows that the monetary policies and government practices used to help curtail a recession also can foster inflation.
Over time, the recipe might look like this: The government buys troubled assets to return liquidity to the frozen credit markets and, later, to stimulate the economy. It also engineers low interest rates. (We’ve already seen this happen.) To finance the increased debt load, the Federal Reserve expands the U.S. money supply by adding more cash in circulation, thereby diluting the dollar’s value on world markets. Attracted partly by the cheaper dollar, U.S. and overseas consumers begin buying U.S. goods again, which fuels a return to U.S. economic growth. But they now are buying with depreciated dollars, eventually causing prices to rise as goods and services command more dollars.
How likely is this scenario? Northern Trust’s experts predict the level of inflation will rise noticeably in a couple of years. They also believe, however, that with proper guidance from the Fed, the rate of inflation can be held within acceptable norms.
“People shouldn’t get the idea that we’re talking about a return to 1970s-style double-digit inflation. We’re not,” says Paul Kasriel, Northern Trust’s chief economist. But while noting that the current crisis has often been likened to the Great Depression, Kasriel says, “We’re unlikely to experience a persistent deflationary environment like the early 1930s, either. Some mild inflation is likely to return some time in 2011 or 2012, and the Fed will have to address that.”
As a result of this recession’s scale, and the amount of government intervention that has been required, economists are watching a number of situations closely.
The Market for Government Assets
The assets on the Fed’s balance sheet rocketed from less than $900 billion at the end of December 2007, when the recession began, to $2.25 trillion at the end of 2008, as the central bank bought securities and extended credit to financial institutions in an attempt to stabilize the economy. While the vast majority of those purchases are “very safe,” according to Fed Chairman Ben Bernanke, the central bank has had to take on a lot of debt to finance it.
“Inflation is a worry, but I put some faith into what the Federal Reserve is doing — that these investments are something the Fed is planning to unwind, rather than just a dramatic creation of money that it can’t get out from under,” says Thomas Root, a Drake University finance professor. “But the question then is how fast the Fed will be able to do this. If it can’t do it in a reasonable amount of time, then it will need to find ways to finance the debt, and that goes toward the idea of a broader creation of more reserves.”
The Fed’s plan is to sell its assets as the market grows, but it is critical that the safer assets be sold quickly. If the market for the government’s assets develops too slowly, the Fed may be forced to print money to finance the debt it incurred acquiring those assets.
As of July 23, the Fed’s balance sheet was still at $2.024 trillion. But Janet Yellen, president of the Federal Reserve Bank of San Francisco, downplayed this concern in a June 30, 2009, speech to the Commonwealth Club of California. “Many of the assets that [the Federal Reserve has] accumulated during the crisis, such as Treasury and mortgage-backed agency securities, have ready markets,” she noted.
Vanishing Manufacturing Capacity
Economists traditionally view a large output gap — the difference between actual economic growth and maximum economic growth — as a sign of low inflationary pressure. Right now, U.S. manufacturers have a lot of excess capacity — the potential to produce more goods than they are actually making. But Kasriel worries that the real gap may be smaller than it appears, given that some of the untapped manufacturing potential is unlikely to return.
“A lot of that excess capacity is related to the auto sector, and it’s going to be a long time before demand for automobiles rises to where it was in 2006 and 2007. And the auto sector is shrinking in this country, so some of that capacity is never coming back,” Kasriel says.
Motivation for Inflation
America is in debt. Historically, that hasn’t been such a bad thing because other nations have seen the United States as a reliable debtor and have purchased its debt at low interest rates. But if our debt becomes less attractive to other countries — and nations like China are beginning to grumble — they will demand higher rates. If America’s borrowing costs increase, that will lead to inflation.
At the same time, some economists theorize that America’s debt also offers the government a less-obvious motive to encourage inflation. Inflation would devalue the dollar versus international currencies, and as a result, America’s debt would decrease, at least in nominal terms.
“You’ll never hear a Treasury official acknowledge this [as a strategy], but we are debtors, as a nation, and debtors prefer inflation to deflation,” Kasriel says. “In an inflationary economy, your nominal income is rising but the nominal value of your debt is staying the same, so it’s easier to pay off that debt.”
Pace of Growth in Developing Economies
The pre-recession booms in fast-developing economies such as China and India imparted a disinflationary impulse to the rest of the world by significantly increasing the global supply of goods and services. The economic crisis slowed that growth and diminished this inflation-braking effect. Some economists worry that if these economies don’t recover fully, the removal of the disinflationary effect could spark global inflation.
Other observers expect these emerging markets to bounce back quickly and lead the recovery. But there’s a danger there, too: If those developing, manufacturing-focused economies rebound too quickly from the recession, they could fuel global inflation by driving up prices for commodities such as oil and copper.
“There could be an increased emphasis on domestic spending in developing economies in the coming years, implying that the era of cheap imports from them is over,” remarked Kasriel.
Rebounding Spending Habits
And finally, economists are paying close attention to consumer spending habits. Although it’s seen as unlikely, if consumers resume spending and borrowing at their pre-recessionary levels, the economy will grow quickly and fuel inflation. “Ideally we’ll have a slightly lower consumption rate and a little higher savings rate coming out of this,” Root says. “That can hurt us short-term, but will be healthier in the long run.”
What Should You Do?
So, how should investors interpret this? Be cautious, observant and don’t overreact. “The biggest concern for an investor is getting back to where you were,” Root says. “If you’re thinking about saving for retirement, then your strategy should be to be patient. It’s not a fun answer, I know, but that’s all there is.”