Fiscal Spending and Inflation

With the United States facing the worse economic climate since the Great Depression (pardon my use of the most overused and annoying phrase of 2008, although "credit crisis," "Wall St. vs. Main St.," "toxic assets," and "too big to fail" are formidable contenders) there is little dispute among economists that the Obama administration will have to employ some degree of fiscal stimulus in order to promote economic growth. The type and size of the package remains a debate with suggestions ranging from giant infrastructure projects to smaller green initiatives, and a combination thereof. However, there are still some naysayers that argue that such a broad fiscal spending policy will flood the economy with money, and ultimately result in significant inflationary pressure.

First, I would remind this aforementioned group that we are in the midst of one of the most deflationary economic environments in modern history (real estate values plummeting, commodity prices under significant downward pressure, re-pricing of financial assets, etc).

Secondly, we should consider the role of non-traditional monetary policy (aka quantitative easing) as a provider of stimulus.

Lastly, we must consider the non-accelerating inflation rate of unemployment (NAIRU), which is commonly believed to be in the 5%-6% range. The Keynesian argument as it relates to the NAIRU is that when the unemployment rate is above the NAIRU (i.e above 5%-6%), inflation will rise and as a result the unemployment rate decreases (reference the Phillips Curve.) In contrast, when the unemployment rate is below the NAIRU (i.e. below 5%-6%) inflation will fall and as a result the unemployment rate increases (again reference the Philips Curve). There is very little debate that in the short-run we will see economic conditions get worse and the unemployment rate continue to climb from its already lofty 6.7% (with some economists even forecasting a peak at 10% unemployment). As a result we will continue to experience increased deflationary pressure. After we reach a peak in unemployment (possibly 5pp above the NAIRU) the upward inflation and downward unemployment adjustment that will follow, and in turn bring the measures in line with the NAIRU, is likely to be very slow, further dismissing rapid inflation concerns.