Inflation: Why the Fed is confused

In the previous post, “Truly pitiful: Federal false helplessness in the face of inflation,” we discussed Federal Reserve Chairman Jerome Powell’s strange attempt to fight inflation by, of all things, raising prices!

Yes, that is precisely what he does when he raises interest rates, his sole inflation-fighting tool. Those higher interest rates increase the prices of virtually every product and service.

When businesses borrow, which most companies do, the higher interest increases their costs, which they must recoup by raising prices.

When farmers borrow, which most farmers do to pay for planting, they include interest costs in their selling prices when they harvest.

When you rent an apartment or house, the owner’s higher mortgage interest cost is reflected in your rental payment.

You may wonder, as I do, how the Fed (and many economists) concluded that raising interest rates reduced the prices of goods and services.

I suspect it comes from the belief that inflation comes from too much buying (Powell’s “overheated” economy). No one knows what an “overheated” economy is, but the phrase makes it sound like Powell knows what he’s talking about.

Since raising interest rates discourages people from borrowing, that seemingly would fight inflation. Of course, inflation itself discourages people from buying, so Powell intentionally causes inflation to cure inflation.

And if that weren’t nonsensical enough, discouraging people from buying is, by definition, causing a recession.

In short, Powell wants to cure inflation by causing it; to do so, he tries to cause a recession without actually causing one. If you understand it, please let me know.

Powell wants us to believe he is a baton-wielding maestro, using interest rates to masterfully conduct our economy as if it were a symphony orchestra, and he expertly navigates between inflation and recession.

In reality, he’s more like a carpenter with only one tool, a hammer, using it to remove scratches from furniture.

Here is an article that attempts to describe what I believe is the primary confusion he and his fellow economists suffer.

Inflation has a big impact on your finances and occurs when the prices of goods and services increase over time.

Inflation occurs when the prices of goods and services increase over a long period of time, causing your purchasing power to decrease.

High inflation can occur as the result of a variety of factors. However, economists often divide the root causes into two categories: demand-pull inflation and cost-push inflation.

And there it is. The common, perhaps universal, belief is that inflation either is demand-pull or cost-push. 

I guess you’ve heard those terms. Most economics texts contain them. But what exactly do they mean? A few paragraphs later, the article will explain. But first, a bit of misinformation:

Inflation is a normal part of the world’s economic cycles.

The concept that inflation is “normal” and is part of the world’s “economic cycles” is designed to make you believe it’s inevitable. It isn’t.

Inflation is not “normal.” It’s abnormal. Nothing is “normal” about inflations, hyperinflations, stagflations, recessions, or depressions. To call them “normal” is to call smallpox and broken legs, “normal.”

And it’s not part of any economic “cycle.” The definition of “cycle” is: “A round of years or a recurring period, especially when certain events or phenomena repeat themselves in the same order and at the same intervals.

To call inflations regular “cycles” is to say, “It’s no one’s fault. They just happen and are to be expected.” Inflations don’t just happen. They are caused by mismanagement and/or extraordinary events and certainly do not repeat at the same intervals.

Inflation occurs when the prices of goods and services increase over a long period of time, causing your purchasing power, or the amount of goods and services you can buy with a single unit of currency, to decrease.

In short, inflation means that your money may not be able to buy as much today as it could in the past.

That sounds exactly like what Powell’s raising interest rates does.

But why does inflation happen in the first place?

It often comes down to an imbalance between two different economic forces: supply and demand. Supply describes how much of a good or service is made and sold, and is driven by the businesses that are selling the good or service.

Demand, on the other hand, refers to how much of a good or service is purchased at a specific price, and is driven by consumers. If demand outpaces supply, inflation tends to follow.

Economists often divide the root causes into two categories: demand-pull inflation and cost-push inflation.

Demand-pull inflation is driven by an increase in total consumer demand. If consumers suddenly start spending more money than usual, businesses may find themselves selling more goods and services than they anticipated.

If these businesses are unable to keep up with the increased consumer demand, their remaining stock becomes more valuable, and prices may rise.

This kind of inflation tends to happen during periods of high consumer confidence, such as when unemployment rates are low and wages are high.

Cost-push inflation occurs when production costs rise. Unrelated to consumer demand, these increased production costs may lead to a decrease in total supply and a subsequent increase in prices to compensate.

These definitions exhibit some of the usual confusion about inflation. Inflation occurs when production costs rise (as was caused by Powell’s interest rate increases —  to fight inflation).

However, increased production costs don’t lead to a decrease in total supply. It’s the reverse. A shortage of raw materials, parts, and labor leads to increased production costs.

This kind of inflation is commonly observed when the price of oil increases, making manufacturing operations more expensive. For example, the 1970s energy crisis was largely responsible for the cost-push inflation that occurred during that time period.

The energy crisis of the 1970s was very simply an oil shortage causing prices to increase—period. In fact, all inflations in history have been caused by shortages, most recently shortages of oil and/or food.

The still-current inflation was caused by COVID-19, which led to shortages of oil, food, lumber, steel, paper, computer chips, labor, and almost any other product or service.

It was not “cost-push.” It was not “demand-pull.” COVID-19 kept people home. We had a shortage of labor, which led to other shortages.

There is no “demand-pull inflation.” Consumers did not “suddenly start spending more money than usual.” They never do. 

Consumers might suddenly start buying Furby dolls, Taylor Swift albums, or Ozempic® for weight loss, but consumers never suddenly start spending more money.

As for “cost-push” inflation, this is akin to saying, “The cause of inflation is inflation.” Cost-push is a meaningless definition.

Every inflation in world history has been caused by a shortage of critical goods and services, notably oil and/or food, which then causes other products and services to suffer shortages.

It’s also possible for inflation to result from factors unrelated to the economy. Natural disasters or major world events can disrupt supply chains and reduce the amount of goods available, driving up prices on the stock that remains.

It’s also possible for a combination of these factors to occur simultaneously or for one to occur as the result of another.

In other words, all inflations are caused by shortages and not by excessive government spending, as so many economists claim.

How does inflation affect interest rates? Inflation is a complex issue, but one way to control it is through federal monetary policy.

When the Federal Reserve — America’s central banking system, also known as the Fed — detects rising inflation rates, it responds by raising the federal funds rate. This is a special interest rate related to lending between commercial banks.

An increase in the federal funds rate causes a corresponding rise in interest rates on auto loans, mortgages and other types of credit, making it more expensive to borrow money.

Increases in the cost of borrowing money can help to slow down consumer and business spending, allowing supply chains to catch up to the production of goods and services, which can in turn lead to a drop in prices.

Said simply, “The increased cost of borrowing increases the cost of goods and services, aka ‘inflation.’ The Fed fights inflation by causing more inflation.”

Ideally, this curbs inflation and stabilizes supply and demand without longer-term consequences such as a recession. When inflation is low once again, the Fed may decide to decrease interest rates, making it easier to borrow money and encouraging spending.

Wait! If high interest rates cure inflation, one should expect low rates to cause inflation.

But that hasn’t happened. For much of a decade, interest rates approached zero, and inflation was low. Only when the COVID-caused shortages hit did we have inflation.

The cause of inflation is scarcities of critical goods and services, mostly oil and food; how should we cure inflation? Cure the scarcity of oil and food.

Although Congress assigned the cure-inflation assignment to the Fed, Congress and the President have the tools to cure inflation, while the Fed does not.

The federal government has the infinite power to create stimulus dollars that would help the producers of scarce products to produce more.

Are we short of oil, food, computer chips, lumber, steel, paper, and shipping? Then, the federal government should give money and tax breaks to domestic producers and importers to alleviate the shortages.

Don’t try to cut federal spending, as many economists advise. Contrary to popular wisdom, federal spending has never caused inflation. If directed appropriately, it can cure inflation.

Those vivid photos of people pushing wheelbarrows full of currency are misleading. Printing higher currency paper didn’t cause hyperinflation; it was a harmful response to existing shortages.

Rodger Malcolm Mitchell
Monetary Sovereignty

Twitter: @rodgermitchell Search #monetarysovereignty
Facebook: Rodger Malcolm Mitchell

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