Situation shows that inflation is going in a galloping rate

There are genuine fears that inflation at a galloping rate is just waiting to pounce. The economy of USA is indicating some of the classic symptoms that precede inflation of the worst type.

A basic principle of economics is that prices go up when the government prints too much money; to put it simply – when too much of money is running after less number of goods.

Why do governments aim at rapidly generating money? They do so because of monetary problems. This happens when spending by the government is more than what is collected through taxes. The government then turns to printing extra money.

These two points explain the hyperinflations in the history of many countries. It seems the USA will soon have to walk along the same path. There are huge deficits in the budget and plenty of growth in money. The deficit of the federal government was during the first quarter of fiscal 2010 year, $390 billion calculating to 11% of GDP.

The Federal Reserve has been busy quickly creating money. By monetary base is meant the currency added to the reserves of the bank. This comprises the yardstick by which supply of money is measured. It is directly controlled by the Federal Reserve. This figure has increased to over double during the past two years.

But despite these two classic indications for uncontrolled inflation, USA has been seeing only modest increases in prices. Over the previous one year the Consumer Price Index (not including food and energy) has gone up by hardly 2%. Long term interest rates have remained comparatively low. This points out that the bond market is not too much concerned about impending inflation. Why?

This is partly because although USA has jumbo budget deficit as well as sharp growth in money, one is not being caused by the other. Bernanke, the chairperson of the Federal Reserve, has been printing dollars not to feed the spending of the government but to save the financial system and give a prop to the ailing economy. Also this is because the banks have been content to hold a good amount of the new dollars as extra reserves.

Normally the banks utilize this money by lending and thus money supply grows along a parallel line. But in these abnormal days the banks are sitting on idle cash. Thus M2 (currency + deposits in checking and savings accounts) have grown in the past two years annually by only 6%. With the return of normal times the banks will start lending, money supply will start flowing and staggering inflation is sure to set in.

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