We know there is going to be a large fiscal surge in the US (the latest estimate is a stimulus of $675-775bn, which is a bit lower than numbers previously floated). This will likely arrive as the US recession deepens and fears of deflation take hold.
The precise outcomes for 2009 are, of course, hard to know yet – this depends primarily on the resilience of US consumer spending and whether large international shocks materialize. But we can have a sense of what happens after the fiscal stimulus has played out (or its precise consequences become clear). There are two main potential scenarios.
First, the fiscal strategy works. In this case, the US pulls out of recession reasonably quickly (perhaps by the second half of 2009). Once this seems likely, the Federal Reserve will want to cut back on its quantitative easing and perhaps even think about raising interest rates. But this will be hard to do for political reasons – the Fed will feel pressed not to quash an incipient recovery, so it will err on the side of keeping interest rates low and credit available on generous terms. At the same time, a great deal of the fiscal stimulus will be working its way through the pipeline for at least two years. The net effect is inflation and presumably a weakening of the dollar (although the latter of course depends on what others are doing around the world.)
Second, the fiscal strategy does not work. In this case, the US recession deepens and we head into a serious global slump. Some more fiscal stimulus might be offered, but faith in its effectiveness will decline sharply. The next policy move in this case is even more quantitative easing (i.e., essentially issuing even more money). This would not usually be appealing, but the global depression would be fed by and feed into serious deflation, and the consensus will shift from “avoid inflation over 2%” to “any inflation is preferable to deflation”. The net effect is again inflation, at least in the US and probably more broadly.
Of course, there are other possibilities. The fiscal stimulus could reflate the economy just enough, i.e., so that growth returns to potential (whatever that is after a crisis of this nature), but not “too much” – so that prices increase but annual inflation never rises significantly above 2%. This scenario seems rather too ideal, and to require too many things to go right, to be high probability.
It is also possible that in a global depression/deflation scenario even the Fed could not make inflation positive. But this also seems to be quite a remote possibility.
So inflation seems hard to avoid, irrespective of how the upcoming fiscal moves play out.