The risks of inflation

Understanding the inflationary potential of recent government actions

By Craig Alexander, Vice-President and Deputy Chief Economist, TD Bank Financial Group

The Parliament buildings in Ottawa stand out against a summer sky.

Trillions of dollars are being pumped into the global financial system to help spur economic growth and repair the system.

In recent months, governments around the world have boosted the supply of funds to combat a synchronous global recession and what may likely prove to be the worst economic downturn in the industrialized world since the 1930s. Many have wondered whether these policy actions, intended to boost economic growth and repair the global financial system, will prove inflationary. This speculation is very reasonable.

One of the oldest tenets of economic theory is that an increase in the supply of money will ultimately lead to higher prices. Economists in the 1500s, for example, noted the inflationary impact of the influx of gold from the New World on Europe.

Given the trillions of dollars that have been pumped into the global financial system of late, will inflation become a problem? The answer is maybe.

Decreased demand slows inflation

There are two reasons why inflation may not accelerate. First, the global recession means that demand for goods and services by consumers and businesses is declining and world trade is contracting. The loss in demand tends to push inflation lower. The concern, however, is that this might lead to deflation. The one sector that can try to provide an offset by boosting its demand is government.

Government can also try to limit the decline in demand by consumers and businesses through stimulative economic policies. To some extent, the government policies are deliberately inflationary to counter the risk of deflation.

As an economic recovery eventually occurs, policy should then be adjusted to ensure that inflation does not accelerate too much. There should be time to accomplish this, since the recession may lead to significant unused resources (i.e., unemployed workers and idle plants and equipment) that would need to be absorbed before inflation becomes a major risk.

Credit crisis could reduce inflation risk

Another factor that could mitigate the risk of inflation is the current credit crunch. According to economic theory, the influx of money itself does not increase inflation. The theory states that if the money supply is increased, as those funds circulate through the economy and are used to buy goods and services, this circulation will ultimately lift prices. However, money is not circulating normally at the moment.

For example, much of the money being pumped into the U.S. banking system is being used to recapitalize financial institutions. It is ending up in the vaults, not in the hands of consumers and businesses. If the circulation of money suddenly improved, there could then be an inflation problem. However, this risk could be avoided if the government cuts back on the supply of funds as the circulation gradually improves.

The conclusion is that there is a risk of inflation as a result of recent government actions, but it is only a possibility. The odds of an inflation problem are low in the near term. However, inflation may accelerate if government policy is not prudently rebalanced as the economic recovery and the repair of the financial system unfold.

Inflation risk snapshot

There are two reasons inflation may not accelerate even though trillions of dollars are being pumped into the global financial system to help spur economic growth and repair the financial system:

The concurrent global recession — demand for goods and services is declining and trade is contracting. This diminished demand tends to dampen inflation.
Conventionally, increased money supply raises prices. However, as a result of the credit crunch, money is not circulating normally at present.

Although the odds of inflation may remain low in the near term, they might accelerate if government policies are not prudently rebalanced as stimulus efforts begin to take hold.