What causes inflation and why is it bad?
What is Inflation? Well, most of us think of inflation as rising prices. And, indeed, prices rise during a period of inflation, but the price of all goods and services generally does not rise at the same rate. Some prices may even drop while others rise at a much higher rate.
Rising prices are symptomatic of inflation, but not the cause. A weighted average of price changes is how we measure inflation. The Bureau of Labor Statistics calculates the rate of inflation based on the price consumers pay for a mix of food, energy, “commodities” (tangible goods), and services. This statistic is called the Consumer Price Index (CPI). Sometimes you will hear of a number called “underlying inflation”. They calculate this by leaving food and energy out of the CPI on the grounds that food and energy prices are “too volatile” and would skew what is really happening.
OK: but what causes inflation? Let’s look at the monetary side of the economy, not just the price side. At any time there is a finite amount of money in the economy. People think of money as currency; but in fact, checking accounts and certain other highly liquid financial assets and obligations are included in the definition of “money”. The Federal Reserve System (the “Fed”) is responsible for controlling the money supply. (Incidentally, people think that the Fed is a huge organization that makes gigantic profits at the expense of the “people”. But in fact, every year the Fed gives its profits to the US Treasury. The amount of this payment in 2021 was $107.4 billion. .)
The Fed can use federal debt purchases and interest rate controls to increase or decrease the money supply. If they lower interest rates, individuals (and businesses) tend to borrow more. This increases the money supply. If they raise rates, it stifles some of the demand for money and the supply drops.
Let us now see how the money supply increases following the purchase of new federal debt by the Fed. It’s really simple. The Fed creates more money by writing a check on itself which it uses to buy new Treasuries. The government now has more money to spend and the Fed has more obligations. The money supply is more important.
Is a growing money supply good or bad? It depends. If the expansion of the money supply is accompanied by an increase in the production of goods and services, there is a rise in our standard of living. If the money supply increases faster than production, the holders of money will drive up prices and there will be inflation.
The Fed is walking a tightrope. Their mission is to allow the money supply to grow fast enough to support economic growth (measured by gross domestic product, or “GDP”). Economic growth, in turn, lowers unemployment. We want to have low unemployment (3 or 4%?). But if the money supply increases too quickly, we have inflation. An inflation rate of around 2% is considered “acceptable”.
Does this mean that every time the federal government runs a deficit, and therefore issues more debt, the result will be inflation? Not necessarily: it depends on who buys the bonds. Private investors, including corporations, especially banks and insurance companies, often buy federal bonds. If this makes it possible to sell all the bonds, there is no effect on the money supply: the money is simply transferred from the accounts of private investors to those of the Treasury.
But lately the government has run up huge deficits and is therefore trying to sell huge amounts of new debt, and the private sector just can’t buy it all. And while public debt is sheltered from the risk of default, the risk of inflation increases. If the inflation rate is higher than the interest rate, investors will have less purchasing power at the end of the year than at the beginning. This is called a “negative real rate of return”. And the government has put a lot of pressure on the Fed to keep interest rates low (around 1 or 2%). Soooo, the Fed has to buy all the bonds, which means the money supply is growing fast and we have inflation.
How much inflation do we have? An organization known as USA Facts collects a large amount of government data and reports it (on the web) clearly and accurately. They report the following information on inflation: From December 2020 to December 2021, the CPI increased by 7.04%. The average annual inflation rate over the 10-year period from December 2010 to December 2020 was 1.74%. If the inflation rate over the next 10 years averages 1.74%, it will take $118.84 to buy what you can get for $100 today. If the average inflation rate is 7.04%, after the next 10 years, what you can buy today for $100 today will cost $197.45.
The Fed’s holdings of US Treasury securities in December 2010 were $1,007,837 million ($1 trillion); in March 2020, they held $2,502,624 million (two and a half trillion dollars); December 2021, $5,652,272 million (almost $5.7 trillion). In other words, there was an increase of about $1.5 trillion over the 10-year period from 2010 to 2020, or about $150 billion per year. But over the past 21 months, the increase has been $3.2 trillion (a rate of about $1.83 trillion per year. Meanwhile, what was happening to the economy?
Over the period from 2010 to 2020, GDP grew from $15.0 trillion to $20.9 trillion, translating to an average annual rate of just under 3.4%. Note that this growth rate is almost double the average inflation rate of 1.74% – a good period. In 2021, we had inflation above 7%, but the most optimistic estimates of GDP growth hover around 5.5%. This number is likely to decrease with the second and third revisions (in February and March). Either way, inflation is outpacing GDP growth, which is not good.
The Fed announced that it would take measures to reduce inflation starting in March. This means that they will raise interest rates and curb the expansion of the money supply. This will require fiscal discipline at the federal level. It will be difficult to achieve.
Why is inflation undesirable? There are several reasons. First, it makes corporate profits look bigger than they really are. The accounting process is based on “historical cost”. Assets are depreciated using the original cost of machinery and buildings. When there is inflation, the dollar cost is usually significantly lower than the current replacement cost. In addition, the cost of parts inventory is often less than the replacement cost of used inventory, so the cost of parts is underestimated. Since investors rely on accounting statements, we have an inefficiency in capital allocation. It also results in corporations paying higher income taxes than they should.
Moreover, it is easier for companies to raise prices than for workers to raise their wages. Consequently, conflicts and resentments abound.
The only real winner with inflation is a debtor who owes amounts of money that do not adjust for inflation. Who is the biggest debtor in the world? Why, it’s the good old US of A. How’s that for the incentive?
How can companies and individual investors position themselves to benefit from inflation (or, at least, minimize the pain)? Well, first you need to reduce your holdings of fixed monetary assets such as bonds or mortgages which will only produce the contractual dollar amount of income. If the rate of inflation is high (the value of the dollar falls), your real income (in terms of purchasing power) will fall – and if the rate of inflation is higher than the interest rate you earn, your income real will be negative. Instead, invest in “real” assets (land, gold, gems, buildings, etc.) that will increase in value with inflation. On the other side of your balance sheet, add monetary debt. It takes some confidence, but raise your mortgage or buy an expensive car on credit. The value of the asset should increase and the “real” debt burden should decrease.
Willis (Bill) Greer is the retired dean of the College of Business Administration at the University of Northern Iowa. He lives in Rollins.
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