Fed Policy is Reason for US Inflation
March 6, 2011
It was a little more than a year ago that some observers of the economy were warning us about the likelihood of price deflation and the negative effects that would have on the economy. That seems to have passed; now inflation is a concern for many. So, let’s start with a basic definition. Inflation is a general and sustained increase in overall price levels. Another way of thinking about inflation is that it is a general and sustained decrease in the purchasing power of money. Thus, with inflation what is in our wallets today will buy us less tomorrow.
Inflation is an increase in overall prices, not a change in relative prices. Even if the price of some product were to increase, this increase, by itself, would not bring on inflation. Let’s use gasoline as an example. As people spend more on gasoline or gasoline related products, they will have less to spend on other items. Less money to spend will decrease the demand for other things causing those prices to fall. That is, relative prices of products will change but general prices will not increase.
While people do a pretty good job of monitoring (and complaining about) overall price changes, little is said or understood about the causes of these events. These causes are fairly straightforward -- they are the economic forces that increase demand for a product without increasing the supply of the same. Although these dynamics might not seem to be inflationary initially, once they have been set in place, they eventually lead to inflation.
Almost always, the culprit for inflation is monetary policy, which is determined by governors of the Federal Reserve System (Fed). The followers of Milton Friedman, who stated that “inflation is always and everywhere a monetary phenomenon,” are convinced that inflation is not possible without an enabling increase in the money supply.
Since 2009, the Fed has been engaged in what appears to be an ambitious monetary expansion program. No matter how you define the money supply (and there are many different definitions) we have seen increases. A narrow definition of the money supply (called the monetary base which includes most liquid assets) more than doubled in 2009. The broader M2 measure of the money supply, which includes the monetary base plus other accounts such as checking accounts, money market funds, savings accounts etc., indicates an increase of a more modest rate of about three percent. Recently, the Fed has been buying another $600 billion of government bonds. This purchase will certainly increase the money supply as the Fed writes a check for these bonds and, magically, the money is created.
The result of this policy and more money in circulation has become evident in the value of the dollar compared to some other currencies. For example, with respect to the euro, the value of the dollar has fallen about 25 percent since 2000. Although it has stayed about equal with the British pound, it has decreased about 20 percent relative to Chinese yuan. This decrease in the value of the dollar in terms of other currencies is one reason we have seen increases in prices of goods we see in our stores and the shelves.
Ben Bernanke, the Chairman of the Federal Reserve System, has stated he is 100 percent certain that the Fed could control an outbreak of inflation above 2 percent. Others say that the increases in the money supply and the devaluation of the dollar over the past two years have already sown the seeds of inflation that will be much higher than 2 percent. History is on the side of the critics of Chairman Bernanke. A year from now we should be able to judge who is right, but in the meantime the contents of our wallets may dwindle at least 2 percent.
George Vredeveld, Director of the Economics Center and the Alpaugh Professor of Economics at the University of Cincinnati’s College of Business.
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