Why Would the Fed Want Inflation?

Chairmen Powell has said the Fed would let inflation rise... but why?

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When the U.S. entered a recession due to the coronavirus pandemic, there were talks of inflation. Due to breakdowns in the global supply chain or the one-two punch of extraordinary monetary and fiscal policy, people had reason to worry. Fed Chairman Jerome Powell publicly acknowledged that if inflation did rise, the Federal Reserve would not try to tame it and instead let it run.

This was startling, to say the least.

We grew up with horror stories of what inflation can do to a country and its economy. Weimar Germany's hyperinflation is an often-cited factor in the lead-up to World War II. More recently, we saw countries like Venezuela, with the highest oil reserves in the world, degrade into chaos. And countries like Zimbabwe became internet jokes with its $1,000,000 notes. Even the U.S. had a dangerous run-in with inflation during the 1970s.

So why would the Federal Reserve want inflation?

To understand the Fed's motives, we must understand exactly what inflation is and its place in the economy.

What Is Inflation?

This is a question that most economists argue about. Then again, economists will argue about almost anything.

The generally agreed view is that inflation is a measure of the decrease in a currency's purchasing power. In simpler terms, inflation measures how much the value of our money has decreased. It tells us how much less we can buy with our money.

Think about it this way. If you look at the prices in the early 20th century, you'll notice that having $100 was a big deal. Nowadays, $100 isn't much to celebrate — that's inflation. The value of that $100 is worth less today than it was 100 years ago.

Economists debate about how to measure inflation and what causes it. The most widely adopted view is that you start with a basket of goods and services used daily. You keep track of the price changes over a number of years. In fact, that's what the U.S. Bureau of Labor Statistics does when it releases its monthly Consumer Price Index (CPI).

But how do you factor in the price of technology going down even when general inflation is going up? Some people say that the CPI is really a measure of living cost rather than the cost of goods.

And how are we meant to account for the increase in quality over the years alongside inflation? The largest TV in the 1970s ran you a few hundred dollars, was 23 inches, and got only a few channels. Compare that with today's TVs, and you will see that the leap in quality more than offsets inflationary pressures.

These are the exact problems economists are trying to grapple with as they debate how to measure inflation accurately.

Should I Be Worried About Inflation?

When you hear stories of Weimar Germany’s hyperinflation or the terrible conditions in Zimbabwe brought on by their inflation, it is easy to get very nervous whenever the topic is brought up.

The important thing to remember is that inflation has been going on all around you throughout your entire life, just to varying degrees. It has been notably absent in the last decade, but that is an outlier in the grand scheme of things. An easier way to visualize long term inflation is to look at a chart of the pricing power of the U.S. Dollar:

As you can see, inflation has been steadily increasing for decades, and we have managed to survive and thrive with it.

Just because there has been little to no inflation now doesn’t mean it will stay that way in the future. The truth is, no one can predict with certainty what the inflation rate will be two, five, or ten years from now.

If you are still nervous about the idea of inflation, the simplest solution would be to invest in anti-inflationary assets such as gold or real assets such as real estate. With today’s democratization of finance, it is easy to invest in these assets through a broker with small sums.

One other important action you can take to give yourself peace of mind against a sudden spike in inflation is to start tracking your expenses. If inflation were to hit, your day to day expenses would spike up with it. This means that it would be beneficial to track where your money is going today and see for yourself if the prices start climbing.

Thankfully there is a host of easy to use software and applications that allow you to take care of both of these things under one roof, such as Personal Capital.

>>Further Reading: Personal Capital Review 2022

The Causes of Inflation

Rising prices cause inflation. Simple enough. But economists disagree on why prices rise. The split tends to fall between three views: demand-pull, cost-push, and built-in inflation.

  1. Demand-pull is the best known. This theory states that demand outstrips production. In other words, when you have more dollars chasing fewer goods, the market raises the price to absorb that excess demand.
  2. Cost-push focuses on the production side of the equation. This theory believes that price increases come from a rise in production cost, through either cost of labor or cost of resources. Unions and new minimum wage laws, for example, raise the cost of labor. And resource prices depend on the supply-demand economics of the commodities markets.
  3. Finally, we have built-in inflation, also known as the “self-fulfilling prophecy.” Here, prices rise due to a collective belief that prices are likely to rise. For example, a labor union hears rumors of inflation, and across-the-board price increases. In response, it demands pay increases to match the price increases. This creates a cycle where the price of production increases, ironically leading to the price increase, the union was afraid of in the first place.

Which theory is right? Well, it seems to be a mixture of all three, but no one knows for sure. This is obviously simplifying things as entire dissertations have been written on this topic.

And other factors serve to complicate these theories further. These factors include monetary stimulus (like the Federal Reserve policy has taken since the Great Recession) and unemployment below a certain level.

How the Fed Manages Inflation

The Federal Reserve follows a mandate with two goals: maximum employment and price stability. Price stability means managing inflation. To do this, the Fed uses several tools. Most economists consider these as being contractionary policies. These tools aim to slow the economy to prevent price increases.

Open Market Operations

One of the Fed's most used tools is the Federal Open Market Committee (FOMC). Whenever the central bank wants to inject money into the economy, it buys securities from member banks. This gives the banks more money to lend out. And this causes them to lower their interest rates and increase the amount of money they lend out.

The Fed does the opposite when it wants member banks to charge higher interest rates. It demands member banks buy securities from it. This absorbs any excess cash the banks have. And that leads them to be more stringent with their lending, which leads to less credit.

The Federal Funds Rate

The most famous tool at the Fed's disposal is the federal funds rate, which it sets at each meeting. This is the rate that banks can charge each other for holding overnight loans. Banks generally lend their excess cash overnight to other banks to make sure they all comply with the minimum reserve requirement (which is also set by the Fed).

The rate's announcement is a widely followed event for all market participants as it has wide-ranging consequences for the economy. Everything from your credit card interest rate to your auto loan to your mortgage is based on this rate. When it goes up, the cost of interest on all the economy loans goes up with it.

Signaling

Believe it or not, one of the most potent tools the Federal Reserve has at its disposal is simply telling people what their plans are. Surprisingly, this policy is relatively new and is meant to counter the third theory of price increases, people's expectations.

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 was unconvinced and kept acting as if inflation would continue despite the rising rates. When a recession hit and the Federal Reserve maintained its high rates to combat inflation, the public finally began to trust the Fed's word, and — lo and behold — inflation dropped.

Since then, each Fed chairman has been very careful to signal to the public exactly what its plans are. In fact, this is exactly what has caused everyone to start fearing inflation suddenly. Jerome Powell stated he would aim for inflation above 2% — a clear break from tradition. And if this is achieved, the Fed will not be in a hurry to tame it.

The Benefits of Inflation

We have an idea of what inflation is and what the Federal Reserve can do about it. Now it's time to get into the meat of the matter: Why would the Federal Reserve want inflation?

Benefit #1- Sign of Healthy Growing Econonmy

To begin with, inflation is a sign of a healthy growing economy, as long as it is managed. Think about it. If you know that next year's prices will be higher than they are now, you make your purchases now rather than waiting, saving, and paying more later. This is, in essence, what low inflation does. It spurs spending in an economy, which is the key to healthy growth. Consumption leads to business growth, which leads to wage and employment increases, which leads to more consumption.

Benefit #2 – Protection from Deflation

The second major reason the Fed wants inflation is that it means the economy won't teeter into deflation, which is the opposite of inflation. In a deflationary environment, prices are constantly going down. This sounds great at first glance, but think about what would happen in reality.

People expecting lower prices next year would hold off on purchases and save their money instead. This would cause consumption to stop. Businesses would need to cut wages or lay off employees. Next thing you know, you have a death spiral of lower prices and lower consumption, leading to a stagnating economy.

Suddenly low prices doesn't sound so great, right? We have a perfect example of a modern industrial economy that is facing this very issue: Japan. Japan's had a deflation problem for decades and still hasn't found a solution. This probably worries the Federal Reserve as it also would not know how to counter such a problem.

To make sure the U.S. doesn't become the next Japan, the Fed wants at least a little inflation. This is especially important now as, despite its best attempts, the Fed has failed to get inflation to rise to its 2% target.

Benefit #3 – Decreases Real Value of Debt

The final reason the Fed wants inflation to rise is that the real value of debt decreases in an inflationary environment. Inflation is actually terrific for the indebted — such as people with a mortgage on their house — as their loan value gets cheaper as inflation rises.

And guess who happens to hold a large amount of debt? The U.S. government holds the most amount of debt in the world in absolute terms. It holds an astonishing amount that it is widely agreed that the government will never be able to pay it back.

Letting inflation run would actually give the U.S. Treasury a breather in dealing with its interest payments, which is an issue that has become particularly acute after the huge amount of money spent to stimulate the economy in response to the coronavirus pandemic.

Will the Fed Be Successful?

The question of inflation, like most topics in economics, is not black and white. In fact, there is a very real argument for needing inflation. But the question still remains: Will the Federal Reserve be successful? After all, following the greatest increase in money supply in history (after the 2008 crash), the U.S. barely registered any inflation at all.

Only time will tell. Here is some food for thought; however: Multiple studies have confirmed the old myth that food products are getting smaller. This phenomenon, called “shrinkflation,” has affected hundreds of products worldwide, from tuna cans to toilet rolls. Businesses claim that they must make portions smaller to maintain their current price for consumers. If your money is now buying less product for the same price, is that not inflation in all but name?

Perhaps inflation is already here, and we just aren't measuring it properly.

Isaac Aydelman

Isaac Aydelman is a student of economics and a former soldier. Drawn to financial markets from an early age, he has experience in futures trading and manages his own personal investment account. Isaac is always interested in expanding his horizons and looking out for opportunities in finance.

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