Why Isn’t There More Inflation?

Huge deficits and ultra-low interest rates should have led to serious inflation by now. The great mystery of the past three years is why they haven't.

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The economy of the past three years has puzzled experts and policy makers in all sorts of ways, but the greatest mystery has been the recent decline in the rate of inflation. That may not seem remarkable in a stagnant economy, except that all the major economic theories suggest that prices should now be rising at a fast clip. Like the dog that didn’t bark – which provided the crucial clue for Sherlock Holmes in the story Silver Blaze – the current absence of significant inflation provides a tipoff to what is really happening in today’s economy.

On a very simple level, inflation occurs when there is more money in circulation than there are things to buy. A big Federal deficit can increase the money supply, because it means either that the government is spending more or that tax cuts are boosting individuals’ disposable income. Low interest rates can also expand the money in circulation because they signal that the Federal Reserve is making it easier and cheaper for banks to lend. And an even more potent way for the Fed to intervene is through so-called quantitative easing – i.e., buying government bonds and effectively creating additional money out of nothing.

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What’s most striking today is that all three of these factors are now at extremes that should be fanning the flames of inflation. Deficits of more than a trillion dollars a year are the highest in history. At close to zero, short-term interest rates are at their lowest level in more than 30 years. And the Fed’s monetary base has been expanding at an unprecedented rate. The remarkable thing is that none of this is translating into serious inflation. Over the past three years, some volatile prices, such as those for food and gasoline, have indeed gone up. But there still haven’t been sustained widespread price increases throughout the economy.

Generally speaking, inflation becomes dangerous when it exceeds 3%. Last year, the rate did begin to pick up and reached a disturbing 3.9% in September. But since then, instead of getting worse, inflation has actually slowed down again to a paltry 1.4%. The explanation is that all the money in the world won’t push up prices unless people are willing and able to spend it. So the dog that didn’t bark in this story is the money that didn’t get spent.

Because the 2007-09 recession hit the financial sector especially hard, banks are holding back on lending as they rebuild their capital. Many consumers are over-indebted and are trying to pay down their balances instead of borrowing more. In some cases, their credit lines are being cut or they are having a hard time getting additional credit. Depressed housing prices have not only slowed the turnover of real estate, but have also removed one of the cheapest ways of borrowing – home-equity loans. Finally, although companies are piling up huge amounts of cash, they have no reason to spend aggressively on expansion and new ventures when consumer demand is depressed and the financial and political outlook remains so uncertain.

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More stimulus, by itself, won’t be able to get the economy moving again. The government can run a huge deficit, the Fed can hold interest rates down, and Fed Chairman Ben Bernanke can pump money into the system with a third round of quantitative easing, but that won’t necessarily make the economy speed up – at least not right away. On the other hand, the fiscal cliff, with its spending cuts and tax increases, could depress the economy further. So could a crisis in the euro zone that delivers a shock to the global banking system or a jump in oil prices induced by war in the Middle East.

What the economy really needs for a full recovery is time and stability. Once U.S. banks have cleaned house and rebuilt their balance sheets, once consumers have their debt under control and their home values have stopped falling, and once companies have to start putting their cash to work, spending will pick up. When that tipping point occurs, real estate prices will likely stabilize and then begin to rise again. The price of oil is also likely to start moving higher.  By contrast, the outlook for bonds, especially low-yielding government bonds, is terrible. If the Fed allows interest rates to rise, bond prices would fall. And if inflation resurges, the purchasing power of the bonds’ principal would be eroded. If both things happen simultaneously, it could produce the worst bond market of a lifetime.

No one can accurately predict the timing of any of these changes, of course. And it’s worth keeping in mind that much of this may be beyond anyone’s control. Policymakers can put more money into circulation, but they can’t actually make it circulate. And they have even less influence on the euro zone or on Iran. The current stagnation may simply have to run its course. But once it does and the economy really begins to rebound, it could well be accompanied by a surprisingly fast resurgence of inflation.

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