I suppose a quick lesson is in order about monetary economics, and I'll keep this as brief and as simple as I can. When the Fed cuts interest rates to try to fight recessions, what it really does is flood the banking system with new money it prints by buying up bonds from banking institutions and individuals, thus expanding its balance sheet. Since there's a whole lot of new money in banks, they have a lot more dough to throw around and loan out, so loans have much lower interest rates. The idea here is that companies and/or people will take out more loans since the costs of financing them is much lower, thus spurring economic activity and staving off a recession. The opposite happens when the Fed sees inflation getting too high--it sells bonds to the banks and pulls all of the money it gets from banks and people out of circulation. Thus, banks have less money to loan out, interest rates on loans go up, economic activity slows down. What sometimes follows this is a short recession, and when the Fed sees inflation subsiding, they cut rates down again until full employment is restored. Congrats, you've just learned what the Federal Reserve does.
In any case, the sheer severity of the current economic crisis was such that even though the federal funds rate (this is what the Fed changes when they cut interest rates, it's the rate at which banks can lend money to one another) is currently at zero percent, the economy remains depressed. This is largely, as I've said in previous posts, because of a large household debt overhang from the housing bubble's bursting coupled with depressed aggregate demand in the economy due to high unemployment and reduced consumption.
Now, back to my main point. Austrian-minded people like Peter Schiff and Ron Paul claim that the U.S. is going to enter into a spiral of hyperinflation. They've been saying this since early 2009 and probably prior to it as well. Here we sit, three years later, with the most recent measure of inflation being 3%. Simply put, you won't see me rolling out my wheelbarrow full of money to go buy groceries anytime soon. I've met people who buy into Paul and Schiff's worldview who ardently refuse to believe that the BLS (Bureau of Labor Statistics) data are honest, because the government wants to cover up the fact that they're secretly creating hyperinflation. No, really, I'm not even kidding.
There are two problems with this: the first being that MIT runs a price index called the Billion Price Index that tracks overall price levels just like the Consumer Price Index does. Huge surprise, it lines up almost exactly with the official statistics. I guess the G-men have gotten to MIT as well. The second problem with their worldview is that if there was actually hyperinflation we would see it! It isn't as if the CPI measures prices of eclectic oddities; if prices were hyperinflating, the price of a Chipotle burrito would be something on the order of 60 dollars instead of a bit over 6.
To Austrians, the price level is determined by something called the quantity theory of money. Simply put, it says that for every increase in the money supply, there is an equal increase in the price level. Now, this isn't some obscure Austrian fringe theory, the equation is valid under certain conditions, but the assumptions that the Austrians make are wrong.
Just to give you an idea of how much the Federal Reserve has expanded the amount of money in the economy, here's a graph of the monetary base between 2007 and now (click to enlarge):
It has gone from a bit over 800 billion to 2.6 trillion. The monetary base has more than tripled since the end of 2008. So in order for Schiff and Paul to be vindicated, we would have to have seen something on the order of a 325% increase in prices over the past three years. Instead, we've seen a change in the price level of 4.4% over that time period. I don't think they could be more wrong.
Now, were the economy not depressed, they would probably be vindicated, but it is, so they're not. What they fail to understand (or refuse to believe?) is that inflation only results when something is done with all of that new money that's been created. Banks, still scarred from the financial crisis, are more reluctant to make loans with this new money, and businesses and individuals are still investing and spending less, which is why inflation remains low. This whole financial crisis, despite being horrific and destructive to millions of people, has been a tremendous experiment in macroeconomic policy-making that has vindicated Keynesian views. Until the economy picks back up, inflation and interest rates will remain low. At which point, the Fed will shrink the monetary base pictured above, as it has in the past.
I have no doubt that, as he has for the past three years, Peter Schiff will say that 2012 will be a year of hyperinflation (no, really guys, for real this time!). Like the Oracle of Delphi that he isn't, he will stand up and make that same prediction for the third year running. And be wrong. Again.