Inflation or Deflation?

CAMBRIDGE – The investors that I talk to these days are not sure whether to worry more about future inflation in the United States or about future deflation. The good news is that the answer – for at least the next few years – is that investors should worry about “neither.”

America’s high rate of unemployment and the low rates of capacity utilization imply that there is little upward pressure on wages and prices in the US. And the recent rise in the value of the dollar relative to the euro and the British pound helps by reducing import costs.

Those who emphasize the risk of inflation often point to America’s enormous budget deficit. The Congressional Budget Office projects that the country’s fiscal deficit will average 5% of GDP for the rest of the decade, driving government debt to 90% of GDP, from less than 60% of GDP in 2009. While those large fiscal deficits will be a major problem for the US economy if nothing is done to bring them down, they need not be inflationary.

Sustained budget deficits crowd out private investment, push up long-term real interest rates, and increase the burden on future taxpayers. But they do not cause inflation unless they lead to excess demand for goods and labor. The last time the US faced large budget deficits, in the early 1980’s, inflation declined sharply because of a tight monetary policy. Europe and Japan now have both large fiscal deficits and low inflation.