There is little reason to expect inflation to pick up speed any time soon. Intense price competition, brought on by the recession and efforts to pare inventories, will make it extremely difficult for businesses to make any price increase stick. Given the high current numbers of unemployed workers, the rate of increase in wages and benefits will likely remain quite modest, and businesses will be forced to absorb the effect of declining productivity in reduced profit margins. With demand weak and bloated oil inventories putting downward pressure on prices near term, several more months of declines in the CPI are possible this year.

A number of the media’s financial and economic pundits are now pointing to forecasts of large increases in federal debt, which they conclude will inevitably result in very high inflation. While we agree that high inflation is a serious risk in the intermediate to long term, it will not be because of the size of government deficits and debt per se. Post-World-War-II era periods associated with high levels of federal government debt have, in fact, been associated with lower average inflation than periods with low levels of debt. This does not mean that there is not a problem, but rather that high inflation is not predestined by large increases in federal debt.

The problem occurs because the Fed is likely to keep short-term interest rates near zero for an extended period. The money stock and excess bank reserves will thus grow considerably. The severity of the recession means there is no short-term inflation risk because the total demand for goods and services—and their factors of production, such as labor—is much lower than supply, and because households and businesses currently prefer to add to their cash reserves because of concerns about the safety of other investments, financial or tangible.

However, as the economy recovers, the Fed will have to shrink the excess of money and bank reserves. This may not be as easy as it seems. Banks may not be eager to buy the non-Treasury private debt now held by the Fed, and the Fed may not have enough Treasury bonds to absorb the excess. Political pressures to maintain low interest rates, when they should be moving up, could also come into play.

All indications are that Fed policy makers are sensitive to the issue and determined to act.