Inflation Experiment

    The Fed is "running a laboratory experiment" on what drives inflation: the money supply or the output gap, says Laurence Meyer, a former Fed governor and now vice chairman of St. Louis-based Macroeconomic Advisers."

That's the summary of an excellent Bloomberg article on inflation and the recent government actions. There are two competing heavyweight theories squaring off right now. Call it Keynes vs. Friedman II.

Nobel-prize winner Milton Friedman contended that "inflation is always and everywhere a monetary phenomenon." In other words, when you create too many dollars, it will eventually show up as inflation as more dollars chase the same supply of goods.

SMI tends to agree with the Friedman economic view of the world, so you've been exposed to a regular diet of this sort of thinking. We believe the government's massive spending will ultimately be inflationary (which is why we'll be exploring the inflation topic in the cover article of next month's newsletter).

While Friedman is a big name and his followers are widespread, his view is by no means unchallenged. The primary competing viewpoint on inflation comes from Keynes, whose economic theories dominated for decades (some would say until they were disproven during the 1970s by rampant inflation coupled with stagnant growth; i.e., the infamous "stagflation").

The article explains how the current economic situation is viewed through Keynes' framework:

    At the root of that concern is substantial and growing slack in the economy, which, according to White House chief economist Christina Romer, is operating 5 percent to 10 percent below potential. That means the economy will have to grow a percentage point above trend - reckoned by the administration to be about 2.5 percent annually - for five or more years before the slack is used up.

    The Phillips curve - developed by economist A.W. Phillips using Keynesian concepts - posits that such excess will reduce inflation as firms stuck with idle capacity cut prices and workers facing layoffs accept smaller wage hikes."

In essence, it boils down to this: can the government get away with significant money creation (to help spur the economy out of its present trouble) without causing serious inflation at some point down the line? Friedman would likely say no, Keynes would likely say yes.

Even if inflation is the eventual result, there's the tricky issue of timing. As San Francisco Fed President Janet Yellen is quoted in the article as saying a few weeks ago, "For some time to come, disinflation, and even deflation, will represent greater risks than inflation."