Feldstein worried that inflation is looming

and Mark Thoma responds...

Once we begin to recover, there are three ways to reduce the inflationary pressures from the growing money supply. First, we could simply reduce the money supply. How do you do that? By selling bonds to the public. Feldstein's worry is that the Fed has bought so many private sector bonds (and traded for government bonds in the process) that it won't have enough government bonds to reduce the money supply by as much as needed, and nobody will want to purchase the private sector bonds unless the price is very low, or, saying the same thing, the interest rate is [excessively] high. But high interest rates are undesirable so reducing the money supply may be difficult.

The second choice is to raise taxes. It might happen, but my inclination is to say good luck with that. But I hope I'm wrong, and maybe we can make some headway here. Third, we could reduce government spending. I don't know what the administration's goals are as to the size of government over the long-term, so I can't say for sure how much of the stimulus spending is considered to be temporary, and how much is intended to be permanent, e.g. for health care reform. But much of it was sold to the public as temporary, and I expect the administration to make good on that commitment (though "good luck with that" comes to mind again, but I'm still hopeful). If it doesn't, other goals such as health care reform could be compromised.

And speaking of health care reform, that's where the focus needs to be. The budget worries twenty years from now have little to do with the temporary stimulus measures we are taking today, going forward health care costs are the most important issue by far in terms of the budget, and everything else revolves around solving that problem.

So am I worried about inflation? Somewhat, particularly when I hear that the Fed's independence is likely to come under review by congress. Whatever doubts you have about the Fed's commitment and ability to keep inflation low in the future, I have little doubt that congress would choose to monetize the debt when faced with tough choices about how to solve a deficit problem (would congress have done what Volcker did?). I still have faith in the Fed, but as you can see from the government budget constraint above, what the Fed can do is dependent upon the actions of congress. If deficits persist, it could come down to a choice by the Fed to monetize the deficit - and risk inflation - or allow government debt to pile up and risk high interest rates. Volcker chose low inflation over high interest rates when confronted with a similar choice, but it's not completely clear to me at this point what this Fed will do in the same situation, and how much cooperation they can expect from congress in terms of reducing the deficit.

Posted via web from jimnichols's posterous