Today"s Topic: The Fed and the Inflation Genie
One of the most powerful relationships in economics is the relationship between the amount of money in circulation and the price level. Classical economists (primarily those from the 17th--19th centuries) understood this and, for example, argued that a one-time increase in money of say 50%, would eventually lead to a roughly 50% rise in prices. This phenomenon is not that surprising and is still true in our time.

To combat this recession the Fed has added more liquidity (money) per time period than at any other time in its history. Fed chairman, Ben Bernanke, is an expert on the Great Depression. He argues that had the Fed pushed the money lever in the 1930's, as today, they could have limited one major cause of the recession and avoided deflation. This could have shortened the depression and perhaps it would have just been a really bad recession.

To stimulate the economy the Fed has more than doubled its balance sheet (printed money) and is expected to do that again in 2009--2010. Ultimately, this will lead to a major inflation if not checked. This is not likely to occur in 2009, with the unemployment rate expected to reach 10%. The money is out there, but with sentiment so low, consumers don't want to invest in capital goods and so on (it's like everyone is putting money under their mattress).

Once a recovery starts (late this year or early next year is the consensus), spending will increase and then we could have a serious inflation problem. The Fed says it will start taking money out of the system. However, it is not that easy as coming out of a long recession there will be enormous pressure on the Fed to delay to be sure that the economy gains traction. If they miss their timing, which has happened before, the inflation genie could get out of the bottle.

This issue will be definite concern over the next few years.