Inflation or deflation? The great mystery of our macroeconomic future.

• Author: Feldstein, Martin

The investors that I talk to these days are not sure whether to worry more about future inflation in the United States or about future deflation. The good news is that the answer--for at least the next few years--is that investors should worry about "neither."

America's high rate of unemployment and the low rates of capacity utilization imply that there is little upward pressure on wages and prices in the United States. And the recent rise in the value of the dollar relative to the euro and the British pound helps by reducing import costs.

Those who emphasize the risk of inflation often point to America's enormous budget deficit. The Congressional Budget Office projects that the country's fiscal deficit will average 5 percent of GDP for the rest of the decade, driving government debt to 90 percent of GDP, from less than 60 percent of GDP in 2009. While those large fiscal deficits will be a major problem for the U.S. economy if nothing is done to bring them down, they need not be inflationary.

Sustained budget deficits crowd out private investment, push up long-term real interest rates, and increase the burden on future taxpayers. But they do not cause inflation unless they lead to excess demand for goods and labor. The last time the United States faced large budget deficits, in the early 1980s, inflation declined sharply because of a tight monetary policy. Europe and Japan now have both large fiscal deficits and low inflation.

The inflation pessimists worry that the government will actually choose a policy of faster price growth to reduce the real value of the government debt. But such a strategy can work only in countries where the duration of the government's debt is long and the interest rate on that debt is fixed. That is because an increase in the inflation rate causes interest rates on new debt to rise by an equal amount. The resulting higher interest payments add to the national debt, offsetting the erosion of the real value of the existing debt caused by the higher inflation.

In the current situation, the United States cannot reduce the real value of its government debt significantly by indulging in a bout of inflation, because the average maturity on existing debt is very short--only about four years. And the projected fiscal deficits imply that the additional debt that will be issued during the next decade will be as large as the total stock of debt today. So raising inflation is no cure for the government's current debt or future...