With $1 trillion deficit and $11 trillion national debt, why no inflation?

This puts the government in an awkward position. It can either let the free markets work unfettered or it can intervene. The free market option would allow supply to adjust downward until it meets the lowered demand. This sounds clinical in theory, but in practice this means that millions of people lose their jobs as companies produce less and shed the people who do the producing. The unemployed workers have less money to spend -- thus lowering GDP and leading to more capacity reduction.

To avoid this downward deflationary cycle, the U.S. has decided to intervene. It cut interest rates from 5.25% to 1% and has committed to buy over $7 trillion worth of financial toxic waste to shift financial institutions' bad decisions from their balance sheets to the Fed's. Not only that, but the Federal budget deficit will likely exceed $1 trillion in 2009 and the national debt tops $11 trillion. Regrettably, there is no way to know whether any of this is working. Some think that things would be worse without it -- but there is no firm data.

Where is the money coming from to pay for all this intervention? It appears that investors around the world are clamoring for our short-term government securities. Amazingly, the Treasury has been able to sell 3-month bills for the equivalent of $100 that will return $99 to the investors -- yielding an interest rate of -0.015%. This means that investors are willing to pay the U.S. government a fee to store their money and return it to them safely in three months.

As long as this continues, inflation is not likely to be a problem. But if this flood of cash actually ends up stimulating demand, it could create history's biggest bubble -- coupled with rapid inflation. At that point, our only hope is that the U.S. can balance the need to tap into that growth to pay down the debt and reduce the deficit against the need to constrain inflation by raising interest rates.

In recent months the U.S. has decided that the damage from deflation in the short-term is far greater than that from inflation in the long-term. Unfortunately, the U.S. has put in place the ingredients for massive future inflation without any credible evidence that those measures are fighting deflation.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book, You Can't Order Change: Lessons From Jim McNerney's Turnaround at Boeing, will be published by Portfolio on December 26, 2008.