New Business June 18, 2009, 5:00PM EST

Why the Fed Isn't Igniting Inflation

(page 2 of 2)

Then they have to cut back even more to make ends meet, creating a deflationary spiral.

True, plenty of legit economists don't buy this low-inflation scenario. Sooner or later, they argue, all that money is bound to show up in prices. "We will soon see a resurgence of inflation and an increase in mortgage rates," says Stanford University economist John B. Taylor, "unless the Fed presents a clear and credible exit strategy from the unprecedented explosion of its balance sheet." For starters, Taylor says the Fed should start to wind down its purchases of Treasury bonds right away. Taylor is famous among economists as the inventor of the "Taylor rule," which describes how the Fed would or should adjust interest rates based on inflation and economic growth. He argues that the negative effects of the Fed's easy money may already be apparent in "increasing oil prices and mortgage rates, which will be a drag on the recovery."

Perhaps. But it's not clear that the evidence Taylor cites—higher oil prices and rising mortgage rates—actually indicates resurgent inflation in the U.S. It's not primarily inflation fear that's pushing up interest rates, but rather massive federal deficit spending. Investors are demanding higher yields to take even more Treasury bonds. In fact, the bond market is forecasting inflation averaging only about 1.8% a year over the next decade, judging from the spread between ordinary and inflation-indexed Treasury bonds. As for high oil prices, they probably do reflect speculation about strengthening economic growth—but perhaps not growth in the U.S. Costly oil could worsen the recession in the U.S. by sucking up money that now goes for other things.

Whether inflation could become an issue in two or three years is irrelevant anyway, argues Gluskin Sheff's Rosenberg. The important thing, he says, is to stave off deflation right now: "Once you get onto the slippery slope of a deleveraging, it's extremely difficult to climb your way out."

In the past, countries where consumers retrenched, such as Japan, were able to fight their way out of recession through exports. The catch this time is that lots of countries from the U.S. to Germany to China are pegging their hopes on export-led recoveries. It's mathematically impossible for all countries to improve their trade balances at the same time—"unless we can find another planet to export to," as Princeton University economist Paul R. Krugman joked at a recent lecture at the London School of Economics.

Economists get paid to worry. But a revival of inflation soon shouldn't be at the top of their worry list.

with Ben Levisohn

Coy is BusinessWeek's Economics editor.

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