Inflation or deflation ahead?

Will the U.S. economy experience inflation or deflation in the years ahead? That is the same key question economists were grappling with after the Lehman bankruptcy in 2009, when the U.S. last embarked on highly unorthodox monetary and fiscal policies at a time of high unemployment.

In the decade following the large 2009 Obama fiscal stimulus package and then-Federal Reserve Chairman Ben Bernanke’s bold experimentation with massive bond buying, inflation did not materialize. In fact, over the past 10 years, the Federal Reserve has continued to fret about not being able to get inflation to rise to its 2 percent target. This was the case because large gaps continued to characterize output and labor markets, despite the unprecedented amount of peace-time fiscal stimulus and Fed money printing.

In the period ahead, it is very likely that inflation will once again not materialize to any large degree, despite an even greater amount of monetary and fiscal policy experimentation than occurred in 2009. This time around, it will not occur because of the likely bursting of today’s “everything bubble” in the world’s asset and credit markets. That bursting will be caused by rising interest rates that will be brought on by today’s unprecedented budget policy easing. 

Those making the case that we are headed for a period of high inflation point to the Fed’s money printing. They note that whereas it took Bernanke six years to increase the size of the Fed’s balance sheet by $ 3.5 trillion, it has taken current Fed Chairman Jerome Powell less than six months to do the same thing. They also note that the surge in the broad money supply in 2020 exceeded that in any of the last 150 years for which we have data.

Another source of concern of those in the inflation camp is that never before has the U.S. economy had as large an amount of peace-time budget stimulus as it is receiving today. Not only is President Biden’s recent $1.9 trillion budget stimulus plan more than double the size of the 2009 Obama budget stimulus. It is coming on top of the more than the $2 trillion March 2020 COVID-19 CARES package and the $900 billion December 2020 budget relief package.

To be sure, one must expect that such a massive amount of monetary and fiscal policy stimulus will lay the groundwork for a very strong rebound in the economy in the second half of this year. By that time, most Americans will have been vaccinated. That in turn could lead to the rapid narrowing in labor and product market gaps that could give rise to inflationary pressure.

The inflation worriers overlook that these developments are occurring at a time when the U.S. and world economies are experiencing massive equity and credit market bubbles. One indication of those bubbles is that U.S. equity valuations today are at the same lofty heights that they were on the eve of the 1929 stock market crash. Another indication is that creditors, both at home and abroad, with very compromised economic fundamentals can now borrow at interest rates that are barely higher than those at which the U.S. government can borrow.

The inflation worriers also overlook that any rise in inflation is bound to cause Treasury rates to rise. They will rise either because the Fed will raise its interest rates and start reversing its bond-buying program to prevent inflation from getting out of hand. Alternatively, if the Fed does not act, the bond vigilantes will drive U.S. Treasury bond rates higher in the expectation of higher inflation down the road.

Today’s pervasive equity and credit market bubbles have largely been caused by the historically low interest rates on government bonds occasioned by the ultra-easy monetary policies of the world’s major central banks. Those low rates have forced investors to stretch for yield and to take on an inordinate amount of risk. But if U.S. Treasury rates were to rise, those bubbles would likely burst as investors would be able to get a reasonable return on a risk-free asset and would no longer need to stretch for yield. Given how pervasive these bubbles are, their bursting could very well give rise to serious problems in U.S. and world financial markets that could stop any U.S. economic recovery in its tracks.

All of this suggests that Congress should think very carefully before approving Biden’s proposed $1.9 trillion spending package. It should do so not because such a large stimulus package could put us on the road to many years of higher inflation. Rather, it should so since such a package is bound to burst today’s global everything asset and credit market bubble, which could lead to yet another period of economic weakness.  

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.