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Is the U.S. Facing an Inflation Threat?

Most economists agree that the greatest threat facing the U.S. economy at the moment is deflation -- a downward spiral of prices that can be difficult to stop. But over the long term, the bigger danger may be the return of that 1970s bugaboo: inflation.

Inflation has been quiescent for so long that it's hard to imagine the return of surging prices that destroy purchasing power, deter investment, devalue the dollar and even lead to apocalyptic hoarding. With total government debt north of $11 trillion and $1 trillion budget deficits likely for the foreseeable future, however, some economists say a new bout of inflation is easy to imagine. PIMCO, the world's largest bond investor, is warning clients that "inflation will rise." Even Warren Buffett, a support of President Obama, believes that "we are certainly doing things that could lead to a lot of inflation."

In recent months, the Federal Reserve has pumped billions of dollars into the economy in an effort to unfreeze credit markets. In the year since January 2008, the amount of currency in circulation and bank reserves -- the so-called monetary base -- doubled to $1.7 trillion. It grew 50 percent in the last three months alone. M1, a measure of the money supply in outstanding currency and checking accounts, has ballooned at an annual rate of 23 percent over the last six months, while the broader M2 measure has grown at 15 percent.

Cue Milton Friedman: "Inflation occurs when the quantity of money rises appreciably more rapidly than output," Friedman wrote, "and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation." Although Friedman is dead, his legacy lives on; many economists still subscribe to the notion that printing too much money to pay for deficits can have harmful effects on the economy.
Richard W. Fisher, president of the Federal Reserve Bank of Dallas, has warned about the impact of such profligacy, although he agrees with the Fed's position that deflation is the greatest threat in the short term. "We know from centuries of evidence in countless economies, from ancient Rome to today's Zimbabwe, that running the printing press to pay off today's bills leads to much worse problems later on," Fisher said last May. " The inflation that results from the flood of money into the economy turns out to be far worse than the fiscal pain those countries hoped to avoid."
While Fed chairman Ben Bernanke has consistently warned that inflation is not an immediate problem, he doesn't have a crystal ball -- remember when he denied there was a housing bubble? Bernanke has never explained how the Fed plans to withdraw all the liquidity it has injected in the global economy. In fact, the Fed has hinted at possible economic stumbling blocks ahead (PDF link). "If inflation resumes but the economy does not recover," the St. Louis Fed said in a research paper, "policy makers will face a difficult choice." In other words, how do you raise interest rates to combat inflation when the economy is still stuttering? This happened with painful consequences in the 1970s.
And there has been a whiff of inflation in the air recently. The consumer price index rose 0.4 percent in February, following a similar 0.3 percent increase in January that was the first increase in six months. While economists generally cheered the fact that the economy had edged back from its flirtation with deflation, further price acceleration could edge into dangerous territory.

Some politicians have come to believe that inflation is really not such a bad thing. Your debts become worth relatively less and asset prices for such things as houses rise rapidly, which would help many homeowners whose homes are currently worth less than their mortgages. But the problem with inflation is that once the genie is out of the bottle, it is extremely hard to put him back in. The recession of 1980 is a cautionary tale of how hard it can be for the government to stop inflation once it has taken root. Let's hope Bernanke knows what he is doing on the inflation front.

Image via Flickr user jurvetson, CC 2.0