According to traditional economic theory, inflation should be increasing right now, at a growing pace.  Trying to oversimplify a complex topic, there are three underlying causes that, under different circumstances, would drive inflation. The fact that this is not happening gives us an interesting perspective on the state of our economy and those who influence it.

First, a large Federal deficit would typically increase the money supply and trigger inflation, either because the government is spending more, or because tax cuts are increasing disposable income among consumers.

Second, low interest rates typically expand the supply of money, as borrowers can get financing more cheaply.

Third, the most effective and drastic way to increase the money supply is quantitative easing, which in this case has occurred when the Federal government buys government bonds.

Outlook?

The Congressional Budget Office (CBO) projects a record $1.2 trillion federal budget deficit for 2012, which would make this year the fourth consecutive year of trillion dollar-plus deficits. The CBO also predicted that next year’s deficit will fall just short of $1 trillion, higher than it predicted in its February budget release. Short-term interest rates are at their lowest level in 30 years and are projected to remain near zero until mid-2014. Bernanke’s recent announcement of QE3 a couple of weeks ago suggested that the Fed’s monetary base will also increase, by expanding its holdings of long-term securities with open-ended purchases of $40 billion of mortgage debt each month.

In a different economic environment, these three drivers would signal a rise in spending and inflation, but at the moment inflation stands at only 1.4%. Spending will only pick up when banks, businesses and average Americans rebuild their balance sheets and their confidence, home values increase across the board, and companies begin putting their cash hoards to work.  Clearly, there is no panacea for the ailing economy and at this point it appears that only time, patience and fiscal discipline will bring about stability and confidence in the economy.

It is troubling and unpredictable when economic theory is thrown out of the window. The capital supply chain from the government to banks to investors to business and consumers is inextricably linked and so long as there is unnerving uncertainty about the economic situation (partly fueled by Fed policy), we will have participants in this money supply chain who act cautiously, irrationally or don’t act at all.