The “stag” in stagflation is already underway. Economic growth depends on investment and investment has been suppressed by government intervention and the downturn to the point that the capital stock in our economy is not expanding enough to generate economic progress. I cited Bob Higgs’s work in an earlier post.
The Fed’s expansion of its balance sheet and commercial banks’s build up of excess reserves provides the potential for the “flation” in stagflation. I lack confidence in the Fed to unwind this potential without significant price inflation. The Fed is dominated by officials who favor price inflation. If they make a mistake, they will err on the side of price inflation, not price deflation.
The purchasing power of money is determined by the money stock and the demand to hold money. If they are roughly balanced over time, then money’s purchasing power will be roughly stable. The chart shows that the CPI index in Japan has fallen from just below 103 in 2000 to just below 100 in 2012. In other words, prices were less than 3 percent lower in 2012 than 12 years earlier.