Have low mortgage rates set the stage for inflation?

Fear of inflationary effect from monetary policy such as we’ve seen from the Federal Reserve Board in recent years is not new. More than four years ago, people expressed concern that the “easy-money policy” of the Fed, particularly the quantitative-easing policy (QE), would lead to inflation – and rightly so, except for one thing. The underlying foundation of this effect is based on the simple, erroneous assumption that easy money generates excess demand feeding inflationary pressure.

This is elementary economics; however, there are two problems with this assumption:

First: The argument may be – or in fact is – valid in a closed economy, but not for the economy of the United States. In a closed economy, a limited-supply condition cannot support the excess demand generated by injecting additional money into the closed economy, thereby triggering inflationary pressure. But the American economy is not a closed economy, and the experience of the past quarter century supports that argument.

Second: We need to distinguish between “investment money” and “spending money.” Fed policy injects money into the former by reducing the pressure on the Treasury and bonds market, which has more growth potential than inflationary effect.

For the past 30 years, the fear of inflation caused by the easy-money policies of the Fed has proven to be wrong. The global goods market in conjunction with the global financial market is more dynamic today than it was 50 years ago. Today, the supply side of the market has become so dynamic that any revamping on the demand side quickly adjusts with no pressure on the price level. Today we are worried about deflation rather than inflation, even with the all the quantitative easing that is in place.

In conclusion, there isn’t a chance of looming inflation on the horizon, not even a remote one.

Although the Federal Reserve’s policy was effective in dealing with the financial crisis of 2008 and the subsequent recession, the Fed has not been particularly successful in stimulating economic growth and a robust recovery. As a result, inflation remains low, at around 2 percent (the Fed’s informal target). However, the Fed’s policy has resulted in a huge expansion of the monetary base. So as the economy – and especially the banking system – recovers from the financial crisis, there is the potential for much higher inflation from the increase to the monetary base.

Fortunately, this risk is under constant review at the Fed. There is a lively and open debate at the monthly Federal Open Market Committee meetings with vocal Fed officials on both sides of the debate about when the Fed should take its foot off the accelerator and start putting it on the brakes by tapering quantitative easing. One indication that the Fed has it about right is the spread between normal and inflation-adjusted Treasury bonds. That spread tells us that the financial markets are betting on an inflation rate of just 2 percent for the foreseeable future.