More From Martin Wolf...

A December '08 article in the London Financial Times on how the Fed's most pressing job is to fight deflation, and how it is printing as much money as it wants to do so:

Is deflation a realistic likelihood? Core measures of inflation strongly suggest not. But one measure of expected inflation – the gap between yields on conventional and index-linked Treasuries – has collapsed to 14 basis points. Moreover, yields on 10-year US Treasury bonds are already where Japan’s were in 1996, six years after the latter’s crisis began.

Why then should central banks fear deflation? First, deflation makes it impossible for conventional monetary policy to deliver negative real interest rates. The faster the deflation, the higher real interest rates will be. Second, as explained by the great American economist Irving Fisher in the 1930s, “debt deflation” – the rising real value of debt as prices fall – then becomes a lethal threat. In the US, whose private sector gross debt soared from 118 per cent of gross domestic product in 1978 to 290 per cent in 2008, debt deflation could trigger a downward spiral of mass insolvency, falling demand and further deflation.

To keep the economy afloat, the Fed is basically printing money. In a fiat money system, the Fed can keep doing that forever, but at some point, inflation will kick in, and with a vengeance:

Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government’s ability to service.

Countries without a credible currency may reach this point early. As soon as a central bank hints at “quantitative easing”, flight from the currency may ensue. This is particularly likely when countries remain burdened under a huge overhang of domestic and foreign debt. Creditors know that a burst of inflation would solve many problems in the US and the UK. The US may manage the danger of resurgent inflationary expectations. The UK is likely to find it more difficult. Avoiding deflation is easy; achieving stability thereafter will be far harder.