US Inflation After the Recession of 2007-2009
To combat the economic slowdown and credit crisis of 2007-2009, the Fed took actions that were beyond anything attempted in the last 50 years; interest rates were cut to virtually zero and the Fed massively expanded its balance sheet by purchasing (in addition to the usual Treasury Bills) Treasury Bonds and Mortgage Backed Securities from Fannie Mae and Freddie Mac. In another article I briefly described the policy actions the Fed has taken. This article discusses (and tracks) the possible inflationary consequences of the Fed’s actions.
Many economists believe there is an approximate relation between changes in the money supply and changes in the price level i.e., inflation (see, among many others here and here). While the relation between money and inflation is not precise, few economists believe that large increases in the money supply will not eventually lead to large increases in prices.
Many economists are not worried about this relation in the short run, as they believe that while the economy is below full capacity (when output is below the maximum that the economy could produce or when unemployment is greater than normal) that monetary expansion will not result in inflation. But as the economy recovers and output and employment recover, inflation is likely to accelerate.
So, when the economy recovers (assuming that the US will not face an extended crisis like the 1930s) the Fed will have to figure out how to undo the monetary expansion. Fed Vice Chairman Donald Kohn recently summarized the problem:
…the Federal Reserve’s actions to ease credit conditions have resulted in a tremendous increase in its assets and in bank reserves. Some observers have expressed concern that these actions, if not reversed in a timely manner, are sowing the seeds of a sharp pickup in inflation down the road. As I just noted, near-term prospects appear to be for a decline in inflation rather than an increase. But my colleagues and I are acutely aware of the risk of higher inflation as the economic recovery gains speed. We are firmly committed to acting in a way that preserves price stability, and we believe we have the tools to absorb reserves and raise interest rates when needed. Moreover, we are working with the Treasury to introduce legislation that would enlarge our tool kit for moving away from the extraordinary degree of financial stimulus we have put in place when the time arrives.
This page will track some of the key variables associated with the possible inflationary surge. First, I will characterize the state of the economy, calculating how close production is to capacity. Second, I will track several measures of the policy actions taken by the Fed and finally I will present several measures of inflation.
|Date||GDP Actual||GDP Potential||Output Gap|
Source: Bureau of Economic Analysis and author’s calculations. I assumed that the economy was at potential at 2007IV and that potential GDP grows at 0.75% per quarter (roughly 3% per year).
|Date||Fed Funds||M Base||M2 SA|
|December 2008||0-0.25% (see note)||199.9||109.6|
Source: Federal Reserve Board; Monetary Base (SA) and M2 (SA) expressed as percentage of December 2007 levels. Fed Funds represent end of month values; on December 16, 2008 the FOMC announced that the target rate for Fed Funds was 0 to 1/4 percent.
|Date||CPI All||CPI Core|
Source: Bureau of Labor Statistics;
So what do we see in these data? From the first panel, the economy as I write (May 2009) is 6% below full capacity. From the second panel, starting in September 2008 (after the failure of Lehman) the Fed began a major balance sheet expansion, doubling the monetary base in roughly three months as the Fed purchased assets to try to ease the problems in credit markets. The expansion of the base has only resulted in moderate expansion of broad money and in the third panel we can see that it has had little effect, so far, on inflation. The Fed has a difficult job ahead, and I will track its progress by updating these tables in coming months.
[update June 18 2009 Monetary expansion continues in May, but there is still little evidence of inflation]
[update July 15 2009 the Monetary base declines significantly]
[Update August 14 2009 some evidence of modest monetary contraction in July with little evidence of inflation]
[Update September 26 2009 inflation up as gas prices rise but core fairly stable, monetary base up but M2 contracts]
[Update December 29 2009 The output gap continues to widen (growth in the third quarter below potential), with monetary expansion continuing and a bit more inflation]