Inflation Down the Road Could Cost Taxpayers -- And We Can Do Something About It

The Federal Reserve yesterday announced $725 billion in new purchases of Fannie Mae and Freddie Mac securities to hold up housing finance, along with plans to buy $300 billion in Treasury securities. Before this latest program, the Fed was already running the most expansionary modern monetary policy since the Weimar Republic. On top of $2 trillion in guarantees for a broad range of private securities, the Fed has been gunning the monetary base at an extraordinary rate. Consider the following: The Fed normally expands the monetary base, which forms the basis for credit and the overall money supply, by an average of 1 to 2 percent per month. In September and October of last year, they expanded that base by 58 percent; in November and December, they increased it another 50 percent.

The Fed was right to do all this, in a deliberate if desperate attempt to push enough juice into a severely strained and strapped financial system, to enable it to get back on its feet -- or at least to not slip into a coma. It hasn't worked so well yet, because the financial system and economy are sicker than anyone thought. And now we’re caught in a vicious circle: The financial system’s woes pushed the economy off the cliff, which then took most other economies in the world with it, and now the problems of our economy and everyone else's are intensifying the financial system's weaknesses.

And the Treasury is out in the markets every day selling the government's securities, even when the Fed's not buying. And like some titans on Wall Street, they may be making a bad bet with your money. The bet here is that inflation will be nothing to worry about for another decade; and if that's wrong, taxpayers will pay a big price. At issue here is what's called Treasury Inflation Protected Securities, or TIPS, securities which pay those lending to the government a set interest rate, like any other Treasury security, but one figured off a principal amount that adjusts upward every six months to take account of inflation. At the price TIPS are now fetching, the market is betting that inflation will be nothing to worry about for another decade. And the Treasury is backing up that bet by selling TIPS at very low prices.

The market and the Treasury backing it up are almost certainly wrong this time. Here's what may well be happening: When markets heat up or melt down, they have a tendency to assume that their conditions will persist for as far as they can see (or invest). That can explain what's happening in the TIPs market: They’re selling at a rate and return which assume that today’s extraordinary deflation will just keep on going, for years into the future. That's possible -- but it's very, very unlikely. The economy eventually will stop contacting; and when it does, prices will stop going down. In fact, through the booms and busts of the last 50 years, the U.S. inflation rate has consistently averaged about 2.5 percent per year over any extended period.

Moreover, once the economy recovers this time, the extraordinary steps we're taking to bring about that recovery will almost certainly produce strong inflationary pressures. First, we're currently embracing the most expansionary fiscal policy in our history (at least for peacetime), with multi-trillion-dollar deficits -- and necessarily so for an economy contracting at a six to seven percent rate. And on top of that is the Fed’s unprecedented monetary expansion.

Whatever White House or congressional leaders say about education, climate or health care, the economy and the financial system, and only that, will remain the President’s central focus and task for the rest of this year and well into 2010.

Eventually we will succeed -- and when we do, our wildly expansionary (if necessary) fiscal and monetary policies will extract a cost. One principal cost is almost certain to be higher than normal inflation -- and that's when the TIPS issue will bite us. If inflation is much higher five years from now than the TIPS market expects today -- and you can bet on that -- people who bought TIPS when everyone expected very low inflation will end up making a killing as the value of their securities is adjusted way upwards for the higher-than-expected inflation. We estimate that will cost taxpayers as much as $80 billion in additional debt-service costs. Fortunately, there’s an easy answer: The Treasury can buy back the outstanding TIPS and reissue the debt in conventional securities. Current TIPS holders would get the current value of their securities, and taxpayers could save enough to finance an awful lot of college assistance, health care for children, or R&D in climate-friendly fuels and technologies.

At a time when nearly everywhere we turn, it costs us all billions or even trillions of dollars, wouldn't it be satisfying to save some real money -- and without raising anybody’s taxes or cutting anybody’s program?

For more information, see the new study, "The Benefits to U.S. Taxpayers from an Open Market Buyback of Treasury Inflation-Protected Securities," at this site.