The numbers are sobering. Over the past year, the level of bank reserves has soared more than tenfold, to $830 billion, and the total amount of credit the Fed has extended to the economy has doubled, to more than $1.6 trillion. Furthermore, the government is projecting that this year's fiscal deficit will top $1 trillion, the highest level relative to gross domestic product since World War II.
For anyone who has studied monetary theory, those numbers sound ominous. There's no doubt that inflation is caused by too much money chasing too few goods, and the Fed has certainly created a ton of money.
But look more closely and you'll find that the situation isn't as dire as it seems. Monetary theory teaches that inflation is caused not only by an increase in the supply of money, but also by an increase in the supply of money that overwhelms demand. The financial crisis, however, has led to unprecedented demand on the part of banks to pump up their reserves. As long as the Fed is responding to demand, an increase in the money supply is not inflationary.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Plus, when we examine the changes in the amount of money in circulation, the numbers are much less daunting. The actual amount of currency outstanding -- those Federal Reserve notes that we all carry in our wallets -- has increased by only 7% over the past year. And M2, a measure of the money supply that includes bank deposits as well as money-market mutual funds, has increased by 11%. Much of that came after the Treasury and the Federal Deposit Insurance Corp. guaranteed assets in money-market funds last September and expanded deposit-insurance limits for banks. Bottom line: The Fed's massive infusion of money was a response to the tremendous increase in demand for liquidity by both banks and the public.
Warning signals. Although deflation is in the headlines today, the Fed has to be alert to inflationary pressures in the future. The value of the dollar, the price of gold and, most important, commodity prices have historically been early signals of inflationary pressures. Commodity prices -- particularly oil prices -- are depressed now due to the worldwide recession. But traders expect the price of oil to top $60 a barrel by the end of 2010. So once confidence returns, the Fed must act to withdraw excess liquidity and raise interest rates.
Those large projected federal deficits are manageable for now. As the economy recovers, they should be reduced by increasing tax revenues and the winding down of support programs, such as unemployment insurance. The federal government's debt-to-GDP ratio is now about 70%, not much different than the postÐWorld War II average.
Japan offers a good example of how much debt a developed country can handle without succumbing to inflation. Over the past ten years, Japan has doubled its debt-to-GDP ratio, to 180%, more than twice the average of other developed countries. Nevertheless, by reining in its money supply, Japan has not only avoided inflation but has actually experienced deflation. And the Japanese yen has been the world's strongest currency over the past decade.
Stable prices. All this doesn't mean that reckless government spending can't cause inflation. With Zimbabwe's President Robert Mugabe printing money to pay his supporters, there's no doubt that such spending is the cause of his country's spectacular hyperinflation.
Nevertheless, although President Obama's stimulus package greatly increases the near-term deficit, the data indicate that developed countries with responsible monetary authorities can accommodate liquidity shocks and absorb debt without yielding to inflation. Current policies won't spark inflation as long as policymakers keep their sights firmly fixed on their stated long-term goal of price stability.
-
The Me-First Rule of Retirement SpendingFollow the 'Me-First" rule and you won't have to worry about running out of money when the stock market goes south.
-
How to Plan Your First International Trip After RetirementRetirement paves the way for a world of exciting (and intimidating) experiences. An overseas journey can be an ideal way to embrace this new phase of life.
-
September Fed Meeting: Live Updates and CommentaryThe September Fed meeting is a key economic event, with Wall Street keyed into what Fed Chair Powell & Co. will do about interest rates.
-
Hot August CPI Report Doesn't Shift the Rate-Cut Needle: What the Experts SayThe August CPI came in higher than forecast on a monthly basis, but Wall Street still expects a rate cut at next week's Fed meeting.
-
Dismal August Jobs Report Offers Rate-Cut Relief: What the Experts Are SayingThe August jobs report came in much lower than expected, lifting the odds that several rate cuts will come through by year's end.
-
Can President Trump Fire Fed Governor Lisa Cook?Markets hate uncertainty, especially when it comes to monetary policy and interest rates, and questions about the Fed are compounding.
-
Powell Signals Rate Cuts in His Jackson Hole Speech. Here's What Wall Street is SayingIn his speech at the Jackson Hole symposium Friday, Fed Chair Jerome Powell said current conditions "may warrant" rate cuts.
-
Trump-Era Regulations Will Broaden Access to CryptoThe Kiplinger Letter The president wants to make the U.S. the leader in digital assets.
-
July CPI Report Boosts Rate-Cut Odds: What the Experts SayThe July CPI report shows that tariffs are having a slight impact on inflation, though not enough to keep the Fed from cutting interest rates.
-
What Tariffs Mean for Your Sector ExposureNew, higher and changing tariffs will ripple through the economy and into share prices for many quarters to come.
