As the U.S. economy faced a recession caused by the pandemic, inflation fears rose. The disruption of the global supply chain and the unprecedented monetary and fiscal policies implemented during the pandemic caused people to worry. Fed Chairman Jerome Powell admitted that if inflation did occur, the Federal Reserve would not attempt to control it and would let it run its course. This statement was surprising because history has shown the devastating effects that inflation can have on a country’s economy. Some examples include Weimar Germany’s hyperinflation, often cited as a factor leading up to World War II, and recent cases like Venezuela and Zimbabwe. Even the U.S. experienced a dangerous bout of inflation in the 1970s. The question is, why would the Federal Reserve want inflation? To understand their motives, we must first understand what inflation is and how it fits into the economy.
What is Inflation?
Inflation is a concept that economists often disagree on. However, most agree that it measures the decrease in a currency’s purchasing power. This means that it tells us how much less we can buy with our money. Despite this agreement, there is still debate about how to measure inflation and what causes it. While the most widely used method involves tracking the price changes of a basket of goods and services over time, this approach can be complicated by factors such as changes in technology and quality.
Should I Be Concerned About Inflation?
While stories of hyperinflation in other countries can be alarming, it’s important to remember that inflation has been a part of our lives for a long time. Even though we have seen little to no inflation in the last decade, it could return. No one can predict the inflation rate with certainty. One way to protect against inflation is to invest in anti-inflationary assets such as gold or real estate. Tracking your expenses can also help identify if prices are starting to rise. Many tools, such as Empower, are available to accomplish both of these tasks.
The Causes of Inflation
What causes inflation? Economists disagree on three views: demand-pull, cost-push, and built-in inflation.
- Demand-pull states that demand outstrips production. When more dollars chase fewer goods, the market raises prices to absorb that excess demand.
- Cost-push comes from a rise in production cost, through cost of labor or resources. Unions and minimum wage laws raise labor costs. Resource prices depend on supply-demand economics of commodities markets.
- Built-in inflation rises due to collective belief that prices will rise. A labor union hears rumors of inflation and across-the-board price increases. In response, it demands pay increases to match price increases. This cycle increases production costs, ironically leading to the price increase the union feared in the first place.
Which theory is right? It seems to be a mixture of all three, but no one knows for sure. Monetary stimulus and unemployment below a certain level further complicate these theories.
Managing Inflation
The Fed’s mandate includes two goals: maximum employment and price stability. To achieve price stability, the Fed employs contractionary policies. It has several tools to slow the economy and prevent price increases.
The Federal Open Market Committee (FOMC) is one of the Fed’s most used tools. The central bank buys securities from member banks when it wants to inject money into the economy. This gives banks more money to lend out, causing them to lower their interest rates and lend more. The Fed does the opposite when it wants member banks to charge higher interest rates. It demands banks buy securities from it, which absorbs excess cash and makes banks more stringent with their lending.
The federal funds rate is the rate banks charge each other for holding overnight loans. Banks lend their excess cash overnight to different banks to comply with the minimum reserve requirement set by the Fed. The rate’s announcement is widely followed as it has wide-ranging economic consequences. The cost of interest on all the economy loans goes up with it when it goes up.
One of the most potent tools the Federal Reserve has is simply telling people their plans. This policy is meant to counter people’s expectations of price increases. In 1979, then-Fed Chairman Paul Volcker announced that he would raise interest rates and keep them elevated until inflation was tamed. However, the public needed to be more convinced and acted as if inflation would continue despite the rising rates. The crowd finally began to trust the Fed’s word when a recession hit, and the Federal Reserve maintained its high rates to combat inflation, and inflation dropped. Since then, each Fed chairperson has been careful to signal to the public its plans precisely. Jerome Powell’s statement that he would aim for inflation above 2% is a clear break from tradition. If this is achieved, the Fed will not be in a hurry to tame it.
The Advantages of Inflation
After learning how the Federal Reserve can handle inflation, it’s time to address the central question: why would it want to increase inflation?
Advantage #1 – A Sign of a Thriving Economy
First and foremost, inflation is a marker of a flourishing economy. To elaborate, if consumers know that prices will increase in the future, they’ll be more likely to make purchases now rather than waiting, which can increase spending and stimulate economic growth. This cycle leads to more business growth, higher wages, and increased employment, all contributing to a thriving economy.
Advantage #2 – Protection Against Deflation
The second reason the Fed wants inflation is to avoid deflation, which is the opposite of inflation. In a deflationary environment, prices drop continuously, which may seem beneficial initially, but the consequences are far-reaching.
If people expect lower prices in the future, they’ll delay purchases and save their funds, which can halt consumption. Businesses may be forced to reduce their employees’ wages or lay them off. This can lead to a downward spiral of reduced consumption and declining prices, which can cause the economy to stagnate.
In reality, low prices aren’t as appealing as they seem. Japan serves as an example of an industrial economy facing this issue. Japan has been grappling with deflation for decades and has not found a solution yet. This situation worries the Federal Reserve, as it does not know how to address it.
To prevent the U.S. from becoming the next Japan, the Fed aims to maintain at least a minor level of inflation. This is especially critical as the Federal Reserve has yet to achieve its 2% inflation target.
Advantage #3 – Reduces the Real Value of Debt
The final reason the Fed wants inflation to rise is that the actual value of debt decreases when inflation increases. Inflation is beneficial for those in debt, like people with a mortgage on their homes, since their loan value decreases when inflation rises.
It’s worth noting that the U.S. government holds the most significant amount of debt globally. It’s generally agreed upon that the government will never be able to pay it back. Letting inflation rise could relieve the U.S. Treasury in addressing its interest payments, which have become a significant issue, especially after the vast sums spent to stimulate the economy following the coronavirus pandemic.
Will the Fed Be Successful?
The Federal Reserve’s ability to control inflation is a complex economic issue. While some argue that inflation is necessary, whether the Fed will successfully achieve its goals remains to be seen. Despite a massive increase in money supply after the 2008 financial crisis, the US has experienced minimal inflation. However, there are indications that inflation may be more widespread than reported, such as the phenomenon of “shrinkflation,” where businesses reduce the size of their products while maintaining the same price point. This could mean inflation is already affecting consumers, even if it is not accurately measured.