Source: Deutsche Bank Research

As optimists see green shoots of recovery, inflation worriers are hitting the panic buttons and calling for spending restraint even amidst the worst recession since the 1930s. Deutsche Bank Research says rarely has the inflation outlook given rise to such differences in opinion as today. While some experts - - including the OECD - - warn against deflation, others believe inflation will accelerate strongly in the medium run. It says, to be sure, monetary and fiscal policies are currently moving in unknown territory so - - of course - - caution is advised in the analysis. However, it considers worries about inflation to be exaggerated, even on a 3 to 5-year horizon.

On Sunday, Nobel laureate Paul Krugman, wrote in his New York Times column that the debate over economic policy has taken a predictable yet ominous turn: the crisis seems to be easing, and a chorus of critics is already demanding that the Federal Reserve and the Obama administration abandon their rescue efforts. For those who know their history, it’s déjà vu all over again - - literally.

Professor Krugman says unconventional measures make the conventionally minded uncomfortable, and they keep pushing for a return to normalcy. In previous liquidity-trap episodes, policy makers gave in to these pressures far too soon, plunging the economy back into crisis. And if the critics have their way, we’ll do the same thing this time.

He cites the the example of the US economy growing rapidly from 1933 to 1937, helped along by New Deal policies. America, however, remained well short of full employment.

Yet policy makers stopped worrying about depression and started worrying about inflation. The Federal Reserve tightened monetary policy, while President Roosevelt tried to balance the federal budget. Sure enough, the economy slumped again, and full recovery had to wait for World War II.

His second example is Japan in the 1990s. After slumping early in the decade, Japan experienced a partial recovery, with the economy growing almost 3% in 1996.

US economist Arthur Laffer has warned that the Fed’s policies will cause devastating inflation. He recommends, among other things, possibly raising banks’ reserve requirements, which according to Krugman, happens to be exactly what the Fed did in 1936 and 1937 - - a move that none other than ardent monetarist Milton Friedman condemned as helping to strangle economic recovery.

Krugman says there are demands from several directions that President Obama’s fiscal stimulus plan be canceled and some, especially in Europe, argue that stimulus isn’t needed, because the economy is already turning around.

He says in answer to claims the Fed is risking inflation, that Laffer seems panicked by a rapid rise in the monetary base, the sum of currency in circulation and the reserves of banks. But a rising monetary base isn’t inflationary when you’re in a liquidity trap. America’s monetary base doubled between 1929 and 1939; prices fell 19 percent. Japan’s monetary base rose 85 percent between 1997 and 2003; deflation continued apace.

In the FT today, columnist Wolfgang Münchau warns that: "Central banks and governments therefore risk moving too swiftly out of a recession-mode strategy. When Axel Weber, president of the Bundesbank, publicly talks at this time about how to communicate a rise in interest rates, it tells me that the danger of a premature exit, at least in Europe, is clear and present.

Source: Deutsche Bank Research

Fiscal policy exit strategies were at the top of the Group of Eight finance ministers’ agenda on Saturday, with the Europeans in greater haste than others. Nobody is solving the toxic asset and recapitalisation problems of the banks. Financial regulation does not seem to be extending much beyond populist pseudo-measures on tax havens. Plus there is still financial meltdown potential in the system. Latvia, for example, is a ticking time bomb.

So at this point, I see the chances as roughly even between a global slump and a return to quasi-stagnation. What is so galling about this scenario is that it is avoidable. The central banks took the right decisions. But the political reaction has been near-catastrophic almost everywhere.

Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."

Deutsche Bank Research economists Bernhard Gräf and Stefan Schneider in a paper published last Friday, say that structural changes argue against debt monetisation and “redemption“ via inflation.

The most important structural changes that will likely stand in the way of inflation policies to reduce and monetise government debt are as follows:

1. Independent central banks

Source: Deutsche Bank Research

In the 1980s and 1990s the Bank of England, the Japanese central bank and all central banks of the Eurosystem became independent of political interference. They either pursue explicit inflation targets or are obliged by law to keep prices stable.

Moreover, consensus has been established among the central banks but also within academia that lower inflation rates are desirable both for welfare and distribution-policy reasons. All in all, it is hardly conceivable at present that leading government representatives would call upon their central banks, secretly or publicly, to tolerate higher inflation rates. They would thereby undo all the decades of effort expended on anchoring inflation expectations at a low level. As independent institutions, major central banks are not allowed to directly purchase debt securities from governments to finance their budget. Secondary market purchases, as currently carried out by the Fed and the Bank of England as the credit multiplier fails are designed to inject temporary liquidity into the economy rather than to finance deficits.

The economists say currently, governments are forced to renew approx. one seventh of their gross debt every year. In Germany the average maturity of government debt is 4 1/2 years. With interest payments accounting for 10-20% of total government expenditure, higher inflation rates and thus markedly rising interest rates (inflation plus risk premium) hardly represent an attractive option. Also, roughly 95% of new government bond issues are purchased by institutional investors. However, this group of investors will likely react extremely quickly to changes in the inflation outlook and then demand higher nominal interest rates.

The intensifying debate in the media about potential inflationary risks alone will probably raise public awareness. Many central banks have for years been publishing quarterly inflation reports or forecasts which are of great interest not only to economists but also the general public. Growing public awareness of inflation risks reduces the opportunity for policymakers to levy a stealth “inflation tax.“

Gräf and Schneider say generally speaking, ageing societies are more inflation-averse as their members have large financial wealth and on average fewer opportunities to change their behaviour (i.e. save more) to offset the depreciation of their assets caused by rising inflation.

In addition, an ever larger part of the population depends on nominal benefits from company pension funds or private savings schemes. Government pensions also provides insufficient protection from inflation due to the calculation method for pension adjustments. As this inflation-averse part of the electorate is growing, politicians will find it increasingly difficult to raise acceptance for higher inflation rates.

The US Social Security Trust Fund currently holds US Treasuries worth $2,400bn, i.e. roughly 38% of the total Treasury volume outstanding.

As social security spending is indexed to inflation – at least at present – a monetisation of government debt would create considerable problems there.

The DBR economists conclude:"All in all, the capital markets are just as relaxed about inflationary risks as we are. 10-year bond yields, which reflect investors‘ inflation expectations for the next ten years, have increased somewhat from exceptionally low levels seen a few months ago, but do not indicate expectations of strongly rising inflation. According to the ECB's Survey of Professional Forecasters, inflation expectations for 2013 are at 1.9%.

In light of the deep recession and dramatic capacity underutilisation, inflation looks set to remain extremely moderate in 2009 and 2010 and come to between 2% and 3% in the larger industrial countries over the medium term."