Interest rates and inflation are at a record low, yet stimulus spending has flooded the markets with currency. The valve that turns money creation into inflation is velocity. The velocity is very low because businesses are reluctant to invest and hire in the face of radical new legislation, massive uncertainty, basically poor sentiment.
Even the extension of the Bush rates, Orwellianly called tax cuts, only extends the rates for two years- far too short a time frame to have any real positive impact on producer certainty and confidence.
If political changes improve the outlook and confidence of the producers we can expect to see more investment and spending- more velocity- and this would seem to ignite inflation. We are to trust that the Fed can reduce the money supply to avoid such an outcome. I remain skeptical.
We can also expect to see a short term rise in unemployment as many workers who have stopped looking return to the workforce and become countable. But unless we see a repeal of the health care bill, which is unlikely for at least two years, and other serious cutbacks we will continue to see business remain reluctant to hire.
We need to improve business sentiment to stimulate hiring and investment, but if we succeed we risk igniting inflation and a Fed reduction in the money supply. Inflation is generally considered a better alternative to deflation which could cause a serious problem for the banking system. But inflation could increase interest rates which on our new massive debt could cause serious problems for our currency.
A combination of stimulative fiscal policy and sound monetary policy seems the only way out. Sound money means reducing the debt and cutting government spending in a massive way. A stimulative fiscal policy usually means low taxes and regulation but I would add that adding a sense of certainty and consistency to our business environment that has long been missing could have as stimulative an impact as tax cuts themselves.
The policy of sound money and stimulative fiscal policies has been successful for both parties: it worked for the Republicans under Coolidge and Reagan and for the Democrats under Kennedy and Clinton. As our system has become more progressive the government has become increasingly dependent on the success of the wealthy and the business sector to support its programs. Under this highly progressive tax environment a Supply Side approach should be welcomed by either party.