Inflationary fears: national fiscal policy has entered uncharted territory.

• Author: Gochnour, Natalie
• Position: Economic Insight

I'm frequently asked about the likelihood of inflation raising its ugly head in response to the massive infusion of money by the Federal Reserve since the 2008 fiscal crisis. The recession ended nearly four years ago and yet the Fed continues to intervene aggressively.

Last month the Federal Open Market Committee (FOMC) left its targets, policy rates and monthly asset purchases unchanged. The Fed is currently buying mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. Since 2008 they have purchased more than $3.2 trillion in these securities.

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Monetary policy remains expansionary and many are understandably worried about inflation.

Defining the Issue

Inflation is one of those economic terms that is, at once, simple and complex. Defined as an overall increase in the price level, inflation occurs when too much money chases too few goods. Each dollar buys less as people's perceptions and the law of supply and demand kick in to diminish purchasing power.

If you are already confused, you are in good company. I have an extremely smart older brother who has struggled to understand inflation. He once asked me, "Why can't the government just give every household in the country $1,000 to spend. Wouldn't everybody be richer and the economy larger as a result?"

His question neglects the very foundation of economics: supply and demand. Twice as many dollars in an economy, all things being equal, makes each dollar worth half as much. Currency is just a medium of exchange or a substitute for goods and services. It doesn't have value in and of itself. It's too difficult to trade goods for goods and so we have an intermediary of cash. Currency makes the economy work, but sometimes it gets out of control.

To illustrate this point, economists often refer to the infamous period of hyperinflation in Germany after World War I. Forced to pay huge war reparations, the German government printed more and more money. By the end of 1923, it reportedly took 42 billion German marks to buy one U.S. cent. (And no, that was not a typo.)

Testing the Limits

While mainstream economists are not talking about hyperinflation, they are talking about the difficult dilemma facing today's Fed. In pursuit of maximum employment and price stability, it has entered unchartered waters. In more familiar times, the Fed relied on the federal funds rate to...