Inflationary Fears

National Fiscal Policy has Entered Uncharted Territory

Natalie Gochnour

April 8, 2013

I’m frequently asked about the likelihood of inflation raising its ugly head in response to the massive infusion of money by the Federal Reserve since the 2008 fiscal crisis. The recession ended nearly four years ago and yet the Fed continues to intervene aggressively.

Last month the Federal Open Market Committee (FOMC) left its targets, policy rates and monthly asset purchases unchanged. The Fed is currently buying mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. Since 2008 they have purchased more than $3.2 trillion in these securities.

Monetary policy remains expansionary and many are understandably worried about inflation.

Defining the Issue

Inflation is one of those economic terms that is, at once, simple and complex. Defined as an overall increase in the price level, inflation occurs when too much money chases too few goods. Each dollar buys less as people’s perceptions and the law of supply and demand kick in to diminish purchasing power.

If you are already confused, you are in good company. I have an extremely smart older brother who has struggled to understand inflation. He once asked me, “Why can’t the government just give every household in the country $1,000 to spend. Wouldn’t everybody be richer and the economy larger as a result?”

His question neglects the very foundation of economics: supply and demand. Twice as many dollars in an economy, all things being equal, makes each dollar worth half as much. Currency is just a medium of exchange or a substitute for goods and services. It doesn’t have value in and of itself. It’s too difficult to trade goods for goods and so we have an intermediary of cash. Currency makes the economy work, but sometimes it gets out of control.

To illustrate this point, economists often refer to the infamous period of hyperinflation in Germany after World War I. Forced to pay huge war reparations, the German government printed more and more money. By the end of 1923, it reportedly took 42 billion German marks to buy one U.S. cent. (And no, that was not a typo.)

Testing the Limits

While mainstream economists are not talking about hyperinflation, they are talking about the difficult dilemma facing today’s Fed. In pursuit of maximum employment and price stability, it has entered unchartered waters. In more familiar times, the Fed relied on the federal funds rate to influence borrowing costs and fine-tune economic performance. But the federal funds rate has been close to zero since 2008. The Fed chose to look elsewhere and turned to unconventional stimulus measures—forward policy guidance (a fancy name for public communications) and quantitative easing (a fancy name for large-scale asset purchases).

Not everyone agrees with the Fed’s direction, even inside the tent. The Richmond Fed president and former FOMC member Jeffrey Lacker has at various times been called “Mr. No” and the “voting hawk.” In 2012 he was the sole dissenting vote at each of the Fed’s policy-making meetings. Lacker was quoted in The New York Times saying, “We’re at the limits of our understanding of how monetary policy affects the economy…Sometimes when you test the limits you find out where the limits are by breaking through and going too far.”

The dual mandate of the Fed is to foster maximum employment and price stability. The U.S. economic recovery remains tepid. Fiscal policy is a disaster as Republicans and Democrats in Washington, D.C. fight like, as Tom Friedman has said, “permanently divorcing parents.” And monetary policy continues to sail in the unchartered waters of the post-Great Recession. Rumors are that Federal Reserve Chairman Ben Bernanke, whose current term ends in January, may not seek a third term.

Uncertainty abounds and, as business owners, consumers and citizens, we feel the economic pain of 7.7 percent unemployment, weak consumer confidence and inflationary fears. It’s better here in Utah, but we are not an economic island and cannot sustain the current strong growth independent of the national economy.

The national forecast for 2013 is moderate growth with downside risks. We would do well to approach economic decisions this year with caution and a hefty dose of humility.

Natalie Gochnour is an associate dean in the David Eccles School of Business at the University of Utah and chief economist for the Salt Lake Chamber.

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