Many issues are in dispute in macroeconomics, but one of the things that everyone agrees upon is this: All else being equal, if more money is in circulation, prices will rise. In other words, if there is more money in people’s hands, but there is not an increase in the things they can buy, then the prices for the available things will increase. That’s commonly called inflation. Some level of inflation is natural and even healthy for an economy, but when it gets past a certain point, it becomes debilitating because price increases become unpredictable. That’s why the U.S. Federal Reserve looks at its primary role as maintaining a steady rate of inflation.
However, the Fed also has other responsibilities – primarily, to ensure that there is sufficient “liquidity” (available money) so that banks can lend and people and businesses can borrow. The trick for the Fed is to maintain liquidity without igniting inflation.
In 2008-2009, the Fed chose to focus on the liquidity issue. With the economy struggling, the Fed reduced its interest rate to the lowest point it has been in 70 years; made credit available to large banks on the easiest terms ever; and made other accommodations to raise the money supply. By some estimates, the Fed has increased the potential supply of money by $12 trillion – a staggering sum for a single year.
Simultaneously, the economy contracted. This has meant that fewer products and services are being purchased. For example, the building of new homes or office buildings has come to a halt; not only are buildings not being completed, but all of the things needed to furnish those buildings are not being bought. New car sales are 40% below the rates of a year ago. Even consumer staples such as gasoline and food are on the decline.
As long as people are hesitant to make purchases, the availability of money has not created rapid inflation. But many experts say that the “perfect storm” is coming when inflation will surge, due to the Fed’s generous money policies. Two factors lend credibility to that suggestion, even though the U.S. economy is not suffering from inflation right now. First, it’s early in the process. When the full impact of the increased money supply is felt, it will generate more money in circulation. As banks utilize their additional liquidity (that is, money they can lend), they will pump money into the system through loans to businesses and individuals. And those businesses and individuals will buy things with their money. That will generate more sales, etc., etc.
The second factor is that Americans have, to some degree, undermined the early impact of increased money supply by becoming steady savers for the first time in two decades. For the first quarter of 2009, Americans savings were 4.6% of income; this is the highest rate since the early 1980s, and a complete reversal of 2006-2008, when spending surpassed income (because Americans were spending their savings and going into debt). As long as Americans are uncertain about the future of the national economy and their own financial stability, they will be careful about their spending – and that will put a lid on inflation.
However, at some point, Americans are likely to return to their free-spending ways. Perhaps it will be for necessities – a car to replace one that’s broken, a new roof on a home, medical services that had been delayed. Perhaps spending will be on speculation and frivolities, as it was for most of the past decade. But either way, spending will rise. And when it does, it will create the cycle of new money chasing limited products. That’s the recipe for inflation.
The question will be how the Fed reacts at that point. If it keeps its “easy-money” policies intact, it will fuel inflation. If it acts wisely by raising interest rates and restricting money that banks can lend, it will be able to slow down demand before it surges too rapidly. It will be able to undo the conditions that it has created presently, before they really do generate rapid inflation.