Last Updated Sep 11, 2009 9:19 AM EDT
There are a few other such pieces of conventional wisdom about inflation that need to be addressed as well.
Budget Deficits and High Inflation
The Japanese economy has faced severe difficulties for 20 years, which has led to massive budget deficits. Today, Japan's debt-to-GDP ratio is approaching 190 percent, yet Japan continues to be more worried about deflation than inflation. Over the period, Japanese inflation has been pretty close to zero. Clearly, budget deficits are not the cause of inflation. Beginning 2009 with a debt ratio of about 40 percent, we are a long way from a debt ratio of even 100 percent.
As Milton Friedman explained: "Inflation is always and everywhere a monetary phenomenon." Inflation accelerates when money supply growth exceeds GDP growth for an extended period. There's too much money chasing too few goods.
Money Supply and High Inflation The Fed has engineered a massive increase in the monetary base, creating the risk of inflation. However, the monetary base is just one part of the money supply story -- the other is velocity. Monetary base times velocity equals money supply. The explosive growth in the monetary base was required to offset the dramatic drop in velocity. If the Fed didn't balloon its balance sheet by buying up debt, the credit markets would have frozen.
The growth of the monetary base was good policy. While it creates the risk of future inflation, that result isn't inevitable. The Fed can undo the temporary increase in the monetary base, let its loan programs supporting the credit markets expire and sell off its assets. In fact, over the past month two measures of money supply -- M2 and MZM -- have fallen at annualized rates of 12 and 16 percent, respectively. And velocity continues to decline. The Fed can also raise interest rates to slow velocity. Rapidly rising inflation isn't inevitable.
Even professional economists don't believe rapid inflation is likely, let alone inevitable. The Federal Reserve Bank of Philadelphia's survey of professional forecasters projects inflation over the next 10 years at just 2.4 percent.