Exit Strategy: Inflation

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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 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.


Originally published at the Baseline Scenario and reproduced here with the author’s permission.

3 Responses to "Exit Strategy: Inflation"

  1. Bill Young   December 30, 2008 at 5:58 pm

    I quote from Simon’s article, “yet – this depends (the economic results of 2009)primarily on the resilience of US consumer spending…”Duh, I don’t understand why no prominent “Expert” has acknowledged the fact that this mess started with the collapse of Joe and Suzy Sixpack’s ability to pay their mortgage and their default has precipitated the destruction of the banks, which is leading to the coming Stag/Deflation as Nuriel points out.If not helped in a meaningfull way soon, Joe’s ability to pay his credit cards and his auto loans will mean the bank’s assets supported by their payments will collapse, bringing us back to square one, with many more bank’s going under. The bailout funds will have disappeared into a Black Hole.What is needed is the same process that worked in the First Great Depression but which is apparently anathema to the Powers that be.The government needs to buy up not only the delinquent mortgages but also the still performing mortgages that exceed the value of the homes securing them, which now represents between 15 and 20% of all mortgages and in some California communities, it approaches 30%.These mortgages should then be re written at a value of 80% of the current market value of the home, which arguably is closer to the real market value than the inflated value and frequently fraudulent values attained at the height of the bubble.While this would give the homeowner a second chance, allowing him to stay in his home and arguably giving him some equity to protect, it would result in an immediate write down of the bank’s mortgage related assets. This deficit would certainly be objectionable to the banks, but it would put a floor under what is now a bottomless abyss, look at AIG.Absent such action, the economy will continue a self propelling trajectory to obliviontoward the Second Great Depression!

  2. deflation makes more sense politically   December 31, 2008 at 11:43 am

    The best way to help american consumers and the us government, both major debtors, would be to inflate the currency making their debts smaller in real terms. This would be a mjor transfer of wealth from the lenders to the borrowers, ie. from rich americans, saudis and china (capital) to usa debtor interests. A transfer from the powerful to the weak. Which is why it wont happen.The money creation process is not originating at the debtor level but at the bank recipients of fed largesse. They will use the paper to Capital concentration will increase, labor power will decrease, and the reverse will happen. deflation. transfer of wealth from borrowers to lender capital .

  3. Roland   January 4, 2009 at 1:37 am

    Chinese workers aren’t exactly among the “powerful” in this world. Why be so eager to shortchange them?The Saudi people have sold you their non-renewable natural resources in exchange for your pieces of paper. Why be so eager to shortchange them?Millions of pensioners in your own country rely on savings which are not indexed to inflation. Why be so eager to inflate away the value of their life savings?Is it the fault of any of these groups of people that many consumers in North America bought bigger homes and more vehicles than they could really afford?The answer to capital over-concentration is not inflation. The answer to the over-concentration of capital is the redistribution of that capital.