We’ve looked into the reasons why inflation hasn’t occurred yet. This time, I’d like to answer the obvious next question:
4. When will inflation return?
Inflation is likely to pick up when the velocity of money stabilizes and banks start to lend again. Presumably, this will occur as the economy gains traction.
Whether or not the pick-up in money velocity leads to higher inflation depends on how quickly the Fed pulls the reins back on the extraordinary credit it is currently providing. In theory, the Fed can take actions to reduce the size of its balance sheet, in practice, this will be a challenge.
The Fed has the power to end the extraordinary lending programs in put in place during the crisis, mop up the excess reserves of money in the banking system (by raising the Fed funds rate), and sell off the long-term securities (mortgages and Treasuries) it has purchased. Timing will be extremely tricky however. Time it wrong, and we could go back into a double-dip recession. Given the sheer size of the balance sheet reductions that need to be made, perfect timing may be nearly impossible.
BOTTOMLINE ANSWER: Inflation will return when velocity of money stabilizes and banks start lending freely again.
Source: MARE group