After Fiscal Stimulus Is Applied, Inflation Will Be Hard to Avoid

We know there is going to be a large fiscal surge in the US (the latest estimate is a stimulus of $675-775bn, which is a bit lower than numbers previously floated). This will likely arrive as the US recession deepens and fears of deflation take hold.

The precise outcomes for 2009 are, of course, hard to know yet - this depends primarily on the resilience of US consumer spending and whether large international shocks materialize. But we can have a sense of what happens after the fiscal stimulus has played out (or its precise consequences become clear). There are two main potential scenarios.

First, the fiscal strategy works. In this case, the US pulls out of the recession reasonably quickly (perhaps by the second half of 2009). Once this seems likely, the Federal Reserve will want to cut back on its quantitative easing and perhaps even think about raising interest rates. But this will be hard to do for political reasons - the Fed will feel pressed not to quash an incipient recovery, so it will err on the side of keeping interest rates low and credit available on generous terms. At the same time, a great deal of the fiscal stimulus will be working its way through the pipeline for at least two years. The net effect is inflation and presumably a weakening of the dollar (although the latter of course depends on what others are doing around the world).

Second, the fiscal strategy does not work. In this case, the US recession deepens and we head into a serious global slump. Some more fiscal stimulus might be offered, but faith in its effectiveness will decline sharply. The next policy move in this case is even more quantitative easing (i.e., essentially issuing even more money). This would not usually be appealing, but the global depression would be fed by and feed into serious deflation, and the consensus will shift from “avoid inflation over 2%” to “any inflation is preferable to deflation.” The net effect is again inflation, at least in the US and probably more broadly.

Of course, there are other possibilities. The fiscal stimulus could reflate the economy just enough, i.e., so that growth returns to potential (whatever that is after a crisis of this nature), but not “too much” - so that prices increase but annual inflation never rises significantly above 2%. This scenario seems rather too ideal, and to require too many things to go right, to be high probability.

It is also possible that in a global depression/deflation scenario even the Fed could not make inflation positive. But this also seems to be quite a remote possibility.

So inflation seems hard to avoid, irrespective of how the upcoming fiscal moves play out.

Comments

[Enough Wealth:]

This seems to assume that deflation is relatively easy to "fix". If the initial stimulus doesn't work and deflation becomes a reality, there is no certainty that additional quatitative easing would be effective in reinflating the economy. Once consumers start to expect prices to be lower next year than now, freely available credit and low interest rates (even 0%) are no longer effective in getting consumers to spend. That's why deflation is so feared by central banks around the world.

2008 Dec 30 06:24 AM

[Kaci:]

Of the money we have seen thrown around thus far let me ask you this, that 168 billion that our country borrowed to give away to us in the form of an "economic stimulus package" ...did it do a darn thing to create jobs or stimulate our economy? NO, nothing. And we borrowed the money from China.

This past year the high cost of gas nearly destroyed our economy and society. More people lost jobs and homes as a direct result of that than any other factor in our history.

Fannie and Freddie continue to get all the blame. Of all the homes I have seen lost in my area SW FL and believe me I have seen many, none were due to an adjustable mortgage. They were due to lack of work.

Families went broke at the pump alone. Then added to that most saw record rate hikes at their utility companies. The high cost of fuel resulted in higher production and shipping costs that were passed on to the consumer, in most cases higher prices for smaller packaging.

Consumers tightened their belts, cut back, went out to eat less or stopped totally. Drove around on tires that needed replacing longer, some even quit buying medicines they really need.Unfortunately cutting back and spending less results in even more layoffs. A real economical catch-22.

And, as we are doing the happy dance around the lower prices at the pumps OPEC is planning to cut production to raise prices. They are even getting Russia in on the cutbacks. Oil is finite. We have used up the easy to get to reserves already. It will run out one day.

We have so much available to us. Solar and Wind are free sources of energy. Of course to get the harnessing process set up is somewhat costly it is still free energy.

It would cost the equivalent of 60 cents per gallon to charge and drive an electric car. The electricity to charge the car could be generated by solar or wind at least in part and in most cases totally.

If all gasoline cars, trucks, and suv’s instead had plug-in electric drive trains, the amount of electricity needed to replace gasoline is about equal to the estimated wind energy potential of the state of North Dakota. What a powerful resources we have neglected.

Jeff Wilson has a profound new book out called The Manhattan Project of 2009 Energy Independence Now. www.themanhattanprojec... Powerful, powerful book! Also, if you think electric cars are way out there in some futuristic lala land please check out the web site for a company Better Place. www.betterplace.com/ they are setting up infrastructures in San Francisco, San Jose and Oakland as well as the state of Hawaii to accommodate electric car use.

I think we need to rethink all these bailouts and stimulus packages. We need to use some of these billions to bail America out of it's dependence on foreign oil. Create clean cheap energy, create millions of badly needed new green collar jobs and get out from under the grip foreign oil has on us. What a win -win situation that would be for America at large

2008 Dec 30 07:09 AM

[TCK:]

Somewhat selective to blame all our economic problems on consumer gasoline consumption. Only half of every barrel of oil goes into making gasoline. Eliminate all oil useage related to consumer driving and we still do not produce enough domestically to drive the economy. Also, it would take decades to replace our current fleet of internal combustion engines. Considering the $40,000 price tag of cars like the Chevy Volt it seems more drilling is the best option for many years to come.

2008 Dec 30 08:20 AM

[retired avi...:]

The assumed link between either increased money supply or higher interest rates and higher inflation is a mythical one. Though many examples in history exist of monetary (and fiscal) stimuli accompanying inflation, there are other examples where money supply increases or modestly higher interest rates have not translated to comparable inflation.

Removing this supposed link, the title of the article becomes pure speculation and without meaning.

We must remember that inflation equates to higher prices, depressing the purchasing power of the dollar. Higher prices simply mean that businesses selling goods and services, on average, have raised prices by the inflation rate. That's it. That's the whole deal. Printing moderately more money doesn't cause ANY inflation unless price-setters actually perceive the additional 'easier' money supply and respond. This is actually a tall order, as who can realistically perceive the money supply in a $10+ trillion dollar economy that reaches across the globe?

No, inflation (price raising) usually happens because input costs have gone up, not money supply or interest rates. Oil, recently, at $140 per bbl is a great example of cost-push inflation for transportation and many products. Interest rates, of course, are a cost for many businesses, but there are capital structures available with less debt, so competition will make them preferable when interest rates are high. Businesses with high interest expense thus cannot necessarily pass the cost on to customers. Low cost producers, with less significant interest expense, tend to win over market share over time.

I digress, but I'll just say that inflation predictions tend to be trickier than those with simple models think. Now, many are predicting deflation going forward, like the Great Depression, so if they are correct maybe your inflation and their deflation will just cancel out!

2008 Dec 30 01:06 PM

[Gem Hudson:]

When fractionize out from a reserve of Congressional I.O.U. bonds is inflating. Wealth is not spread around but piece of paper and Chinese holding a whole lot of our treasury notes are going to be pay up in printed up notes. They wouldn't think so. Since China are holding all those treasury I.O.U. U.S. of A. notes and all we can do is pay up in more of those promissory notes. Washington D.C. have nothing else but those promissory notes or pay up in more taxies one way or another.

2008 Dec 30 08:19 PM

[secmaven:]

Every time "green" energy gets to a point of economic viability the big money interests short oil until the price collapses and green energy is put on the back burner again, and again, and again.

2008 Dec 31 03:06 AM