My guess is that within the next year or two, we will experience significant levels of price inflation in the US. Let me explain why.
Inflation is the percentage increase in the price level of goods and services sold in a geographic region. There are several different measures of inflation: the consumer price index, producer price index, the chain-weighted deflator, and so on. Each has issues: it is estimated on a limited basket of goods and services which may or may not represent what each of us buys; it is a biased measure of our quality of life; and, it is frequently reported only to be significantly revised later. But as long as our measure of inflation is equally crappy through time, it will give us a reasonably reliable measure of the changes in the rate of inflation.
Inflation occurs when the rate of growth of the money supply exceeds the level of real growth in the economy. It doesn’t occur in the short run. In the short run, in fact, an increase in the money supply actually lowers the interest rate, or the “price” of money. For us to see a pervasive and wide-spread increase in prices, the growth in money has to exceed the real growth rate for an extended period of time.
What causes the growth rate in the money supply to increase? It’s complicated, but there are basically three things the Federal Reserve can do to increase the money supply: decrease the discount rate (which is basically as low as it can go right now); reduce the reserve requirements of banks (which isn’t likely to happen); or buy a lot of newly issued treasury bonds (or any asset for that matter – more on the creative acquisition of “special purpose” assets by Geithner and gang in a separate post) and pay for them with newly created deposits that it injects into the commercial banking system. This last one is called Open Market Operations (OMO). OMO give the Federal Reserve enormous power and responsibility: it basically gives the Fed the ability to create money out of thin air, and it is the only entity in the US economy that can do that. Banks can’t; businesses can’t; consumers can’t. Just the Fed.
And the Fed is doing a whole lot of that lately. It is hard to surmise from the press reports exactly what fraction of the $300 billion in additional purchases of long-term treasury bonds and the $750 billion purchases of mortgage assets announced on March 18, 2009 were financed with deposit creation, but to the extent they were, the money supply is skyrocketing. Given the subdued growth in real productivity in the US economy, this increase in money supply will translate into period of inflation, the likes of which we’ve not seen in this country for decades. We see evidence of it already in the bond markets.