The financial press is constantly abuzz with talk about inflation. The Federal Reserve targets a 2% inflation rate, but in the years following the 2008 financial crisis, Fed economists fretted about inflation that was “too low.” However, critics of the Fed’s quantitative easing (QE) programs believed that the large QE programs would lead to runaway inflation, which the Fed would have a tough time controlling.
This leaves the casual observer wondering: is inflation good or bad? How much inflation is “too little” and how much inflation is “too much?” What causes inflation and what are the ramifications of “too little” or “too much” inflation? We aim to answer all your questions on inflation below.
The Role of Money and the Federal Reserve
In an economy, money is defined as the total amount of assets held by the public that is readily available to make transactions. In most modern economies today, individuals exchange fiat currency which include notes and coins that have no intrinsic value, but individuals in the economy have confidence to use the fiat currency as a medium of exchange because the government has declared it as a legal form of tender.
Alternatively, money can take the form of currency that can be converted into a physical commodity. Historically, many of the world’s currencies were convertible into gold. Currency that can be converted back into gold is referred to as being on the gold standard. Up until 1971, US dollars were on the gold standard. The gold standard was created in the United States to build confidence amongst Americans that US dollars have value due its convertibility back to gold. Without the US government providing this backstop for US dollars, it would have been very difficult to convince individuals to stop using gold coins as the official form of legal tender in favor of a piece of paper printed by the US government.
In 1971, Richard Nixon announced that the US government would no longer allow for conversion of dollars back to gold, which at the time, was convertible to gold at the rate of $35 per ounce. While the dropping of the gold standard had and still has many critics, the US dollar has still maintained its role as the world’s reserve currency due its widespread use and continued high level of confidence in the US dollar amongst individuals and companies globally.
As the US economy moved into a world of fiat money, the federal government gained more latitude in its ability to influence the money supply, which is the total amount of money circulating in the economy at any given moment in time. Under a commodity-based form of currency, the supply of money is limited to the supply of that commodity available. However, under a fiat currency regime, governments can create more money by simply printing it.
A government’s ability to print money has historically proven to be a slippery slope. While it may seem very attractive for governments to print large amounts of money to pay for social services, infrastructure projects, etc, eventually, investors and individuals in the economy may start to feel that the currency they are holding is worthless due to the irresponsible actions of the government. Therefore, confidence in a fiat currency is dependent on confidence in the responsibility of the government controlling the money supply.
The role of controlling the money supply is typically given to a country’s central bank. In the United States, the central bank is the Federal Reserve. The Fed controls the money supply through its Federal Open Markets Committee (FOMC), which is a committee consisting of the members of the Federal Reserve Board and the presidents of the regional branches of the Fed. The FOMC meets every six weeks to make decisions on monetary policy.
The FOMC controls the money supply through its open market operations. When the Fed wants to increase the supply of money, the FOMC will purchase US government bonds held by the public. Since the public is selling government bonds to the Fed, this increases the amount of currency in circulation. Conversely, if the Fed wants to decrease the supply of money, the FOMC will sell US government bonds back to the public, which will cause the public to decrease the amount of currency it is holding.
Measuring the Amount of Money
The two common measures of the money supply are “M1” and “M2.”
M1 = Currency + Demand Deposits (checking accounts) + Traveler’s Checks + Other Checkable Deposits
M2 = M1 + Savings Deposits + Money Market Securities + Retail Money Market Mutual Funds + Small Denomination Time Deposits (less than $100,000)
As of October 2018, the total M1 supply is $3.7 trillion dollars and the total M2 supply is $14.3 trillion dollars. The M1 supply annual growth rate was 4.1% in October 2018, and the M2 supply annual growth rate was 3.7% in October 2018.
Below is a graph from the St. Louis Fed, showing the annual growth rate of the M2 supply (shaded areas indicate US recessions).
Quantity Theory of Money
The quantity theory of money explores the relationship between transactions in an economy the quantity of money circulating in the economy. It holds that:
Money * Velocity = Price * Output
M * V = P * Y
Let’s assume we live in an economy that only produces cars. This economy produced 20 cars in one year with each car having a price of $10,000. Furthermore, let’s assume that the economy has $100,000 of currency circulating. What is the velocity of money?
$100,000 * V = $10,000 * 20
Solving for V, we get 2. In other words, we can say that the $100,000 of money in the economy has changed hands twice throughout the course of the year.
Why is this equation important? Because it demonstrates that the when the supply of money is increased (or decreased), the other factors in the equation must adjust.
Economists will often make a simplifying assumption that the velocity of money remains constant. In other words, we are making the simplifying assumption that individuals in the economy are not changing their preference as to how much currency they are demanding to hold onto.
Let’s look at the drivers for each factor in this equation:
Money – The central bank controls the growth rate of the money supply
Velocity – Consumer preferences determine the growth rate in velocity of money, which is determined by the demand for how much cash consumers want to hold onto
Price – The price level is ultimately a function of the other three variables. The change in the price level is equal to the inflation rate
Output – Output is driven by the real productive capacity of the economy, which is determined by progress in technologic changes, innovation, etc.
If we take output as a given and we assume velocity of money is constant, then, the greatest determinant of the price level of the economy is the money supply, which is in direct control of the central bank. Therefore, if the velocity of money remains constant, and the Fed increases the money supply, then, the price level in the economy should increase.
Inflation = Rate of change of the price level
According to the quantity theory of money, the Federal Reserve can control the rate of inflation through its control of the money supply. Empirically, this relationship between money supply growth and inflation has proven out in the data. In years with high money supply growth, inflation rates have tended to be higher than in years with low money supply growth.
The Effect of Inflation on Interest Rates
Inflation has a direct effect on interest rates since inflation represents a loss of purchasing power, which lenders expect to be compensated for when lending money. For example, if a lender provides a loan at a 10% interest rate but the inflation rate in the economy is also 10%, then, the lender has not increased their purchasing power. The lender has earned 10% but everything in the economy is now 10% more expensive. For the lender to increase their purchasing power, they must charge an interest rate that is higher than the rate of inflation.
Nominal Interest Rate = Real Interest Rate + Inflation
Let’s assume a lender is charging 10% for a loan, and the rate of inflation in the economy is 3%. What is the real interest rate being earned by the lender?
10% Nominal Rate = Real Interest Rate + 3%
Real Interest Rate = 7%
In this example, the lender is earning a 7% real rate of return since 3% of the 10% nominal return is eaten away by inflation. Based on this equation, we can see how increases in inflation result in direct increases to the nominal interest rates in the economy. Therefore, borrowers end up paying more in nominal interest rates during high inflationary time periods.
For example, if the inflation rate were to increase to 5% and the lender still required a 7% real rate of return, then, the nominal interest rate charged on this loan would have to increase to 12%. When a long-term (more than one year) loan is made at a fixed interest rate, the lender and borrower are both taking inflation risk. Let’s assume a borrower takes a five-year loan at 12% with inflation currently at 5%. If inflation increases to 7% during the term of the loan, the borrower ends up ahead by having borrowed at a lower nominal rate than may been available in the future. Likewise, the lender is worse off for having locked themselves into a loan that doesn’t compensate them for the higher than expected 7% inflation.
The Effect of Nominal Interest Rates of Inflation
Here is where things can get a bit confusing. Inflation is a determining factor in nominal interest rates, but nominal interests can also feed back into inflation. Remember, our quantity theory of money equation is:
Money * Velocity = Price * Output
One of the factors that drive velocity of money is nominal interest rates. If nominal interest rates go up, the demand to hold currency (which doesn’t earn any interest) goes down, which increases velocity. Increased velocity results in increased inflation assuming output is unchanged.
Implicit in the idea that inflation and nominal interest rates create a feedback loop is the notion that expected inflation changes are just as important if not more important than the current inflation rate. For example, if the market believes inflation will go from 2% to 3% due to the Fed increasing the money supply, then, nominal interest rates will increase as a result. The increase in nominal interest rates may then feedback into higher inflation due to a faster velocity of money.
Why does the Fed target 2% inflation?
Here is the official answer from the FOMC:
“The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling–a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.”
According to this statement from the FOMC, the Fed believes that a small positive inflation rate is helpful to avoid deflation, a situation in which prices, including wages, are falling. Deflation can be particularly harmful in economies with high degrees of financial leverage (debt). If businesses and consumers have taken on large amounts of debt, but their revenues / incomes are falling, it becomes difficult to service their debt (which has a principal balance that remains the same even if prices are falling).
Although the Fed doesn’t mention this in their statement, small positive inflation is also thought to be helpful in maintaining the efficiency and competitiveness of the labor market. Over the long-term, various industries will rise in prominence while others will fall by the wayside. For industries that experience slower growth long-term, these industries often need to downsize and become more cost efficient in order to survive. However, it is very difficult for employers to cut nominal wages. Instead, industries can cut real wages by increasing nominal wages at a rate lower than inflation. This allows struggling industries to right-size labor costs over time.
For example, let’s assume that XYZ Newspaper Company needs to cut costs to survive, but the largest cost item for this company is its labor. If XYZ were to raise wages for its newspaper staff by 1% during an environment where inflation is 2%, this achieves a 1% reduction in real wages. This, of course, assumes that XYZ Newspaper can grow its revenues at a rate consistent with inflation.
Expected Inflation vs. Unexpected Inflation
Although there are identifiable costs of expected inflation, expected inflation is for the most part manageable by economies. For example, if individuals expect 2% inflation for the medium to long-term and 2% inflation is what occurs, it allows individuals to plan and adjust according to these expectations. Loans based on a 2% inflation rate will not favor the debtor or the creditor as long as 2% inflation is what occurs.
On the other hand, unexpected inflation creates winners and losers in an economy. For example, let’s assume a bank lends money at a 6% nominal rate and is expecting 2% inflation. This bank is expecting a 4% real rate of return on their loan. If instead, the inflation rate jumps to 6% after making the loan, the bank will earn no real return on their loan. In this situation, the borrower has essentially borrowed at a 0% real interest rate, creating a situation where the borrower wins at the expense of the lender. Instead, if the inflation rate turns out to be 0%, the bank will end up earning a 6% real return on the loan, while the borrower ends up as the loser in this situation, having to pay a higher than expected real interest rate.
In addition, unexpected inflation makes it difficult for those living on a fixed income source such as retirees living on pensions or income from investments. During time periods when inflation spikes, these retirees’ will experience a decline in their buying power if their source of income does not keep up with the unexpected increase in inflation.
Lastly, unexpected inflation simply creates uncertainty, and investors and companies become more risk-averse during periods of uncertainty. Lower risk aversion leads to lower investment levels and lower hiring because it becomes more difficult to forecast what the return profile of an investment will be when the future inflation rates are highly variable.