Will America Soon Have an Inflation Problem?

In response to a question posed at a forum by The International Economy magazine in its Spring 2015 issue:

Not a chance. Fed policy since 2008 has been to tilt against powerful deflationary forces that have yet to abate. How powerful are those forces? Consider this: from September 2008 to date, the monetary base has increased by 336%, from $0.94 trillion to $4.1 trillion, yet the annual CPI growth declined from 5% in September 2008 to a negative -0.1% in February 2015. So, we are talking about quite powerful underlying deflationary forces that will not go away.

But deflation is not necessarily anti-growth. During the second industrial revolution, in the 20 years from 1873 to 1892, the average annual GDP growth was 4.23% and the average annual inflation rate was a negative -2.41%. Over that 20-year period, real GDP grew 145% and the CPI level declined by -43%. This growth-friendly deflation was driven by persistent productivity growth as a result of the economy absorbing the cost-saving effects of railroads, telecommunications, electricity and revolutionary new-materials manufacturing such as the Bessemer process.

The causes of this underlying deflation have not yet been studied precisely because it is “underlying”, i.e., it is masked by the massive growth of monetary aggregates and not measured by the monthly CPI reports. My best guess is that the current bout of growth-friendly deflation in the United States (as distinct from the rest of the world) is due to similar technology-driven productivity gains as seen in the Gilded Age, but also due to cheap foreign labor and competitive devaluations. Proliferating new materials technologies, 3-D printing, rapid advances in robotics, rationalization of processes based on internet-of-things applications, automation, etc., are cutting costs as they penetrate deeper into economic activities, improving some, eliminating others and creating brand-new ones.

The Fed’s accommodative policies of the last six years were aimed at stabilizing the financial system, not at achieving the traditional targets of employment and price level. Therefore, a return to normal policies need not be argued on the basis of whether or not America will soon have an inflation problem. No such problem is likely to materialize, and yet the Fed should tighten its policy rate and perhaps do so sooner than Yellen’s stated timetable.

The reason is that the existing accommodative policies are distorting the resource allocation process and in this sense inhibiting growth. By aiming to stabilize the financial system during and in the aftermath of the 2008 crisis, the Fed’s accommodative policies had no choice but to prop up traditional assets that were under threat by the challenging new technologies. This is a policy that has to end if resources are to be freed up and applied to the emerging technological possibilities. By having given ample advanced notice, the Fed is attempting to execute the shift without reviving the fears of systemic collapse. At this particular time and instance, the Fed’s immediate task is to transform the resource allocation system without collapsing it – not to fine tune the price level and unemployment rate.

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