Inflation Ahead

Currently, the Fed Funds rate is effectively zero. In addition, the Federal Reserve is planning to purchase $300 billion in Treasury bonds and $850 billion in mortgage-related debt. In order to pay for this $1.75 trillion purchase, the Fed is going to simply print money.

We're pretty worried about deflation right now but in the next few years we're going to see high levels of inflation as a result of this monetary policy.

I just finished reading a book about monetary policy by Milton Friedman. The theory is pretty basic: inflation arises when the supply of money grows faster than output. Heading back to Macro 102, the Phillips curve illustrated the inverse relationship between inflation and unemployment.

According to the Phillips curve, high inflation leads to low unemployment because and abundance of money means businesses can hire more people and higher inflation lubricates labor markets. Low inflation means high unemployment for the opposite reasons.

While the Phillips curve may work in the short-run, Friedman rejects it in the long run. After all, inflation takes years, not months, to develop and/or be cured. Also, people begin to expect inflation, thereby removing the positive side of and increase in nominal income.

Friedman writes:
"We have been misled by a false dichotomy: inflation or unemployment. That option is an illusion. The real option is whether we have higher unemployment as a result of higher inflation or as a temporary side effect of a cure for inflation."

I agree with this idea and I am a little worried about the next few years. As soon as we begin to pull out of this recession, the Fed is going to have to tighten interest rates like crazy to stem inflation. In turn, this could potentially create an inflationary recession.