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
2007IV 100.0 100.0 0
2008I 99.8 100.8 -0.9%
2008II 100.2 101.5 -1.3%
2008III 99.5 102.3 -2.7%
2008IV 98.1 103.0 -4.8%
2009I 96.5 103.8 -7.0%
2009II 96.3 104.6 -7.9%
2009III 96.9 105.4 -8.1%

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
September 2007 4.75% 98.8 98.7
October 2007 4.50% 99.0 99.1
November 2007 4.50% 99.6 99.5
December 2007 4.25% 100.0 100.0
January 2008 3.00% 99.3 100.7
February 2008 3.00% 99.1 101.7
March 2008 2.25% 99.5 102.6
April 2008 2.00% 99.2 102.8
May 2008 2.00% 99.7 103.1
June 2008 2.00% 100.3 103.3
July 2008 2.00% 101.2 103.9
August 2008 2.00% 101.3 103.5
September 2008 2.00% 108.5 105.0
October 2008 1.00% 135.7 106.6
November 2008 1.00% 172.9 107.3
December 2008 0-0.25% (see note) 199.9 109.6
January 2009 0-0.25% 205.8 110.7
February 2009 0-0.25% 187.7 111.0
March 2009 0-0.25% 197.9 111.9
April 2009 0-0.25% 210.7 111.2
May 2009 0-0.25% 213.3 112.1
June 2009 0-0.25% 202.4 112.6
July 2009 0-0.25% 201.0 112.3
August 2009 0-0.25% 204.9 111.6
September 2009 0-0.25% 216.4 112.0
October 2009 0-0.25% 232.8 112.4
November 2009 0-0.25% 243.2 112.8

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
December 2007 100.0 100.0
January 2008 100.4 100.3
February 2008 100.5 100.3
March 2008 100.9 100.5
April 2008 101.1 100.6
May 2008 101.6 100.8
June 2008 102.5 101.1
July 2008 103.2 101.4
August 2008 103.2 101.6
September 2008 103.3 101.7
October 2008 102.4 101.7
November 2008 100.7 101.7
December 2008 99.9 101.7
January 2009 100.2 101.9
February 2009 100.6 102.1
March 2009 100.5 102.3
April 2009 100.4 102.5
May 2009 100.5 102.7
June 2009 101.3 102.9
July 2009 101.3 103.0
August 2009 101.7 103.1
September 2009 101.9 103.2
October 2009 102.2 103.4
November 2009 102.6 103.5

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]

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