In today’s FT, Martin Feldstein, professor of economics at Harvard and president emeritus of the National Bureau of Economic Research and and former chair of the Council of Economic Advisers under President Reagan, warns of the inflation that awaits the US.
Whether this larger fiscal deficit leads to an increase in prices depends on monetary conditions. If the fiscal deficit is not accompanied by an increase in the money supply, the fiscal stimulus will raise short-term interest rates, blocking the increase in demand and preventing a sustained rise in inflation.
A primary example of this was the sharp fall in inflation in the US in the early 1980s at the same time that fiscal deficits were rising rapidly. Inflation fell because the Federal Reserve tightened monetary conditions and allowed short-term interest rates to rise sharply.
While he did not concretely provide exit strategies to the current monetary and fiscal policies implemented by the Obama administration, Feldstein recognized that taking all the excess money supply in the market and the reserves of the banks once the economy recovers will not be a very easy task. Even after we recover from this recession, it would be very interesting to see how the Fed will resolve the problem. By then, a new Fed chairman will be sitting and having the headache of his life.