Inflation expectations might also shift if the markets lose confidence in the state of the public finances. Washington is set to produce a deficit this year of $1,800bn (£1,237bn, €1,325bn). The cost of bailing out Wall Street runs to several thousand billion dollars more. Meanwhile, the Fed has promised to expand its balance sheet by more than $2,000bn. Governments that issue debt in their own currencies and control their monetary printing presses do not tend to go bust. Rather, the sovereign default takes place covertly through a depreciation of the currency.
If market participants come to suspect the US government faces insuperable financial burdens and that the Fed is losing its political independence, inflation expectations are liable to change rapidly. Clearly, this issue is a concern to China’s leaders who, having acquired an enormous mountain of Treasury bonds in their foreign exchange reserves, are aware that Americans might seek at some stage to inflate away their foreign obligations.
Edward Chancellor weighs in with a piece on the inflation/deflation debate. Worth reading.