Shuffle - Desmond Lachman Resident Fellow Desmond Lachman

There can be little doubt about the long-run inflationary threat to the US economy posed by the very large excess bank reserves created by the Federal Reserve. However, it is far from clear how imminent that inflation threat might be and how quickly the Federal Reserve should begin exiting from the extraordinary monetary policy loosening of the past year.

There are several good reasons to believe that inflation is not an immediate risk to the US economy and that the Federal Reserve would be ill-advised to prematurely exit from its easing policy. First, one would think that the very large gaps presently characterizing the US labor and output markets will continue to exert downward pressure on wages and prices. Wage incomes are already increasing at their slowest pace in the past fifty years, while core consumer price inflation has been trending downwards.

Second, it would seem more than likely that any recovery from the present economic recession will be unusually weak, which will only further increase the size of those labor and output market gaps in 2010. In particular, one must expect household consumption, which accounts for 70 percent of US aggregate demand, to be severely constrained both by subdued wage income growth and by attempts by households to increase savings as a response to the decline in their wealth. And without meaningful consumption growth, it is difficult to see how one gets a robust and sustainable economic recovery.

Third, one would think that banks are very unlikely to draw down their excess reserves at the Federal Reserve until they have repaired their own balance sheets and until households and corporations increase their loan demand. With unemployment likely to soon exceed the worst case scenario under the Treasury’s bank stress test and with commercial property prices now in free fall, one would think that banks will continue to horde liquidity in anticipation of further loan losses.

These considerations would suggest that the Federal Reserve has ample time to begin exiting from its policy loosening. It would also suggest that the Fed should be mindful of the very real risk of aborting the present incipient recovery by prematurely tightening monetary policy at a time when households and corporations are still in the process of balance sheet de-leveraging.

Desmond Lachman is a resident fellow at AEI.