Inflation in the United States has been remarkably low, despite a lethal combination of extremely loose monetary policy and trillion-dollar annual budget deficits, which apparently have become a new normal.
Economic theory suggests that inflation should have spiraled out of control long ago, but after four years of such policies runaway consumer price increases no longer seem to be a real threat.
The U.S. Federal Reserve, whose two-pronged mission requires it to keep inflation in check and stimulate full employment, clearly believes that inflation will remain under control for the foreseeable future and that it needs to concentrate on resolving the problem of sluggish job creation. In early September, it announced another round of unconventional monetary policies known as Quantitative Easing 3, and vowed to keep buying mortgage-backed securities until the unemployment rate declines.
This is an unprecedented open-ended commitment to print massive quantities of money, at a time when the economy is actually growing, albeit slowly. Since 2008, the Fed has dumped some $2 trillion worth of liquidity into the financial system, and many economists expect another $1.2 trillion infusion to result from its current operations. The Fed’s balance sheet could balloon to $4 trillion by the end of 2013.
Some economists—and Fed Chairman Ben Bernanke is among them—clearly believe that there have been structural changes in the economy that will continue to keep inflationary pressures in check.
There are many definitions of inflation, the most descriptive of which is as follows: the situation when an increasing amount of money chases after an unchanged quantity of goods and services. In other words, inflation is a measure of efficiency in the economy. If consumers have more money to spend, this could result in an inflationary spike in an inefficient economy, since producers will not be able to satisfy extra demand quickly. In an efficient economy, on the other hand, producers will promptly increase supply to meet extra demand.
In the 1970s, the U.S. economy was inefficient and companies couldn’t respond promptly enough to changes in input prices or consumer demand. Higher prices for oil and other commodities translated into price hikes at consumer levels and demands for higher wages. Since the 1980s, however, deregulation, structural and technological changes, the spirit of entrepreneurship, improved management techniques and intensified foreign competition greatly increased economic efficiency. Companies have become more flexible; they have been able to anticipate and respond to various changes in market conditions swiftly.
Whenever there is an increase in demand, a number of producers increase production to harvest consumer dollars. This kind of heightened competition has made price hikes very difficult to implement and sustain, putting a premium on cost control. There simply is no room left for inflation in this highly efficient, saturated business environment.
As a result, official consumer price inflation has been quite low, measuring no more than 2-2.5%. Moreover, a serious debate has been raging in academia and among economic policymakers, some of whom have been encouraging the Fed and other central banks to tolerate higher levels of inflation in order to spur worldwide economic growth. The problem is that based on traditional economic assumptions, lax fiscal and monetary policy and zero percent interest rates should have long ago resulted in high inflation. Central bankers simply don’t have any other tools at their disposal to make price levels rise.