Martin Feldstein Sees High Future Inflation Pressures as the US Fiscal Deficit Increases

In a piece written on Sunday for the Financial Times – Martin Feldstein, the George F. Baker Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, said that the unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation.

Here are a few excerpts:

From FT: ….According to the Congressional Budget Office, the president’s budget implies a fiscal deficit of 13 per cent of [GDP] in 2009 and nearly 10 per cent in 2010. Even with a strong economic recovery, the ratio of government debt to GDP would double to 80 per cent in the next 10 years.

[T]he large US fiscal deficits are being accompanied by rapid increases in the money supply and by even more ominous increases in commercial bank reserves that could later be converted into faster money growth.

The Fed is also creating a massive increase in liquidity by its policy of supplying credit directly to private borrowers. Although these credit transactions do not add to the measured fiscal deficit, the unprecedented Fed purchases of more than $1,000bn of private securities have led to the enormous $700bn increase in the excess reserves of the commercial banks. The banks now hold these as interest-bearing deposits at the Fed. But when the economy begins to recover, these reserves can be converted into new loans and faster money growth.

The deep recession means that there is no immediate risk of inflation. … But when the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit.

This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding… It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.

While the money supply–inflation relationship is an important element in macroeconomic policy as governments try to control inflation, the assumption that somehow supply of money automatically = inflation is fundamentally non-accurate. In 1970s we experienced significant inflationary pressures with CPI index hitting an annualized rate of more than 7% – and yet during that time M1(cash and near-cash in circulation plus checking accounts) rose relative to the real GDP at an annualized rate of about 2.7%-3%. That suggests that there are numerous forces that apply upward pressure to prices which are not driven strictly by money supply growth.

Certainly at some point, and as dictated by economic conditions, we will have to face price-pressure increases. However, that will happen only when the supply of money exceeds the supply of goods available. Currently, our capacity utilization is stagnant-to-negative. But as the demand picks up and productivity increases the Fed will have more than enough time in its disposal to pull back the excess reserves at banks before inflationary pressures start accelerating again.

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