Inflationary Fears

During the Great Recession (many now believe we are experiencing a recovery), the Federal Reserve increased the money supply substantially in order to increase liquidity in credit markets (called "credit easing" as opposed to "quantitative easing"). Some people fear future inflation, and it is difficult to say when the Fed should reduce the money supply. I decided that a comment concerning inflation is central to future discussions, so I wanted to touch on it first.

Quick definition of terms
Inflation is a rise in the overall level of prices in a country, hyperinflation can be seen as out-of-control inflation (often 100%+), and deflation is a reduction in general prices. M0 is a measure of the monetary base. M0 is not a measure of money that is being used for consumption or investment. It is simply a measure of coins, paper money, and bank reserves. There are many measures of the money supply that can be seen here. When the Fed "prints money" it increases M0.

Is inflation bad?
Inflation can be bad, and it can be good. When people think of inflation, they often think of their money being reduced in value. If the money in your bank account stays relatively constant, while prices rise, then you can buy less goods. During hyperinflation (seen in postwar Germany, Zimbabwe and others), the value of money is reduced so fast that money needs to be spent as soon as possible in order to retain its worth. This makes lending almost impossible and can lead to the collapse of economic markets. However, this also highlights a benefit of inflation. Inflation stimulates consumption. In an inflationary environment, holding onto money will reduce its value over time. In America, consumption is two-thirds or more of GDP, so strong consumption is central to economic growth. The higher the economic growth rate, the higher you want your inflation to be. In America healthy inflation is seen as 2-3%, while in developing countries the healthy rate may be much higher

But deflation makes my money worth more! What's wrong with that?
Deflation does sound good to a consumer, and that's the bad part. If holding onto your money becomes a good investment, then people are less likely to spend it. This stifles consumption. With a reduction in consumption, firms are forced to lay off workers, increasing unemployment and reducing production (GDP). This is known as a recession. This scares consumers, so they are even less likely to spend their money. This reduction in consumption again forces companies to lay off even more workers in order to cut costs, and the cycle is repeated. This is known as a "Deflationary Spiral", which some believe characterized the Great Depression.

So What?
Deflationary Spirals are very bad for economies and they are very difficult to get out of. Because of this, the Federal Reserve avoids deflation at all costs, which brings us back to the current market. During this recession, the Fed increased the money supply by a substantial amount, creating fears of future inflation. However this money is simply floating around. Inflation is characterized by more money chasing the same number of goods. If there is more money in the market (read: increase in M0) but not an increase in consumption or investment, then it has no effect on inflation. This can be seen in recent numbers for CPI (an inflation index). From April to October % annual change was under 0%, with .3% growth during October compared to a year ago. It is for this reason that the Fed was, and continues to be wary of deflation. The increase in the money supply has not been accompanied by an equal rise in economic growth, and the Fed will likely leave the liquidity in the market until healthy economic growth is seen.

In the 80s we experienced a "Double Dip Recession" or a W shaped recession. This means that there was a short post-recession period of growth before we dropped back into another recession. Many believe that this recession occurred because the Fed increased interest rates too soon in order to stave off over-inflation. Learning from the past, the Fed has continued to keep interest rates low and M0 high. They will likely wait until they see signs of strong growth before enacting contractionary policy, and when they do so such policy is likely to be introduced cautiously. Until we see true inflation in CPI and PCE numbers, I personally believe it would be foolish to tighten the economic belt. The Fed can act swiftly if need be, so be patient, keep a clear head, and pay attention to the numbers.