Prof. Blanchard presents a tour de force on the nature of inflation. Unfortunately, I must dissent from his analysis.
It is possible that one can see deflation in one sector of the economy (housing) while seeing inflation elsewhere (food and energy). Given that food and energy prices are more central to the economy than housing (and more likely to effect the average person on a daily basis) perhaps we should not dismiss inflation concerns so quickly. Indeed, perhaps the housing "crisis" is masking even deeper inflation problems.
The central error in Prof. Blanchard's analysis is the assumption that the Federal Reserve should act only after inflation is painfully obvious rather than acting proactively. The question is not whether inflation is a crushing burden now, but whether there are signs that it soon will be. What are those signs?
Prof. Blanchard concedes that inflation is on the rise in the last half year. As one can find here, since at least last October we have seen inflation higher than has been normal over the last 16 years or so. Are there other signs of inflation?
The American dollar is in free fall on the world market. This is a sign of a devaluing dollar, which is the real disease of inflation while rising prices are the symptom.
Gold keeps increasing in value. Gold is traditionally thought to be a safe investment in times of inflation, although there is some evidence this is a false hope. In a column four years ago decrying the inflation bogey man, St. Larry Kudlow argued that rising gold prices and sinking value of the dollar suggesting coming inflation, but, he argued, strong economic growth will soak up the excess money supply:
Today's high gold price and weak dollar do signal excess money in the system. However, that liquidity will be absorbed by the reduction in high marginal tax rates on personal income, dividends, and capital gains; high productivity; and rapid economic growth.
In short, more money will be chasing even more goods and services. Hence inflation will be quiescent.
The emphasis is mine. So what happens when the economy slows down, yet gold prices remain high and the dollar continues to tumble in value? Answer: inflation. The Fed should be acting now to strengthen the dollar rather than acting to devalue it further, which is what lowering interest rates will accomplish. In this case economic stimulus should come in a manner that Kudlow would approve, namely through reduction of corporate tax rates, not through monetary policy.
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