On Wednesday, the Federal Reserve is expected to announce its first interest rate hike since 2018. The Fed is expected to boost its target federal funds rate by 25 basis points to combat the greatest inflation in more than 40 years, which is being fueled in part by the coronavirus outbreak. 0.01 percent is equivalent to a basis point.
Is inflation the fault of the Federal Reserve?
Does this ring a bell? Inflation is once again on the rise, and the Fed is blaming supply limitations created by the epidemic while ignoring the main cause: an expanding money supply. It’s always easier to blame something outside of your control and responsibility than it is to blame something within your control and responsibility.
Starting in 1986, I had the privilege of serving on the Federal Reserve Board under Chairman Paul Volcker, who was attempting to bring inflation under control. Volcker was hired by President Jimmy Carter in August 1979 with the mission of lowering the double-digit inflation rate. After taking office, President Ronald Reagan reaffirmed this goal. By June 1981, Volcker had successfully raised the federal funds rate to 20% and slowed the rise of the money supply. The result was not one, but two recessions in a row.
While the monetary policy medicine took its course, the situation in Washington was heated. When Volcker left the Fed in August 1987, the annual growth rate of the money supply had been cut from over 12.6 percent in 1979 to a far more manageable 5.3 percent. Alan Greenspan kept his anti-inflationary measures in place. Consumer price rises had reduced to barely 4.6 percent by the time I left the board in 1989.
The Federal Reserve was well on its way to defeating inflation and keeping it in check for the rest of the century. The lower borrowing rates that came with the decrease in inflation were a nice bonus. Low interest rates have fueled decades of growth and prosperity.
Now fast forward to the year 2020. The government implemented unprecedented fiscal stimulus measures in response to the country’s worst recession in history, resulting in a significant increase in the federal deficit. The Federal Reserve aided these budgetary policies by purchasing a large portion of the freshly issued debt. As a result, the debt-to-GDP ratio hit a new high of 136 percent in November 2021, while the M2 money supply soared from $15 trillion in January 2020 to $21 trillion in November 2021.
The Federal Reserve made a significant adjustment in its operational processes and long-term strategy, which was unconnected to the epidemic yet occurred at the same time. In August 2020, the Fed changed its “Statement on Longer-Run Goals and Monetary Policy Strategy” after lengthy consideration. In it, the Fed essentially tosses the congressional mandate for “price stability” or zero inflation out the window and reaffirms its 2% target for the Personal Consumption Expenditures Price Index. It also included the express condition that times of sub-2% inflation should be offset by periods of price increases of more than 2%. Surprisingly, the phrases “money” and “money supply” are absent from this monetary-policy approach declaration.
After a decade of relatively low inflation, this shift in strategy allowed for an unduly expansive monetary policy. When the epidemic struck, the Fed began enormous quantitative easing by purchasing Treasury bonds and mortgage-backed securities, resulting in a 25 percent increase in money supply. These initiatives were accompanied by the Fed’s direct lending to the public through a dozen Section 13(3) programs.
Prices reacted with a lag, just as Friedman expected. Producer prices were about 10% higher than consumer prices by the end of 2021, while consumer prices were up more than 7% year over year.
Inflation has resumed full throttle at the start of 2022. The Fed, on the other hand, continues to pursue a highly supportive monetary policy, purchasing billions of dollars in Treasuries and mortgage-backed securities each month. How can it make sense to buy these securities when house prices are rising at a roughly 20% yearly rate? Furthermore, the Fed continues to keep its foot on the gas pedal by keeping the fed-funds rate near zero. The Fed continues to add fuel to an already-rising inflationary fire.
Even more concerning is the fact that the Fed has not once referenced the word “money” in its official news releases following each Federal Open Market Committee meeting over the last two years. How can an entity in charge of monetary policy oversight and implementation be so careless and contemptuous of the key assetmoneyover which it has complete control and which is at the center of monetary policy implementation? How long does it take to change an unreasonable policy that defies the congressional mandate for price stability?
The present Fed leadership, including Arthur Burns, is blaming external forces for the significant growth in the money supply during the last two years. As a result, inflation is on the rise once more. The cycle of history is repeating itself.
What mechanism does the federal government use to inflate?
Inflation is primarily caused by the Fed’s so-called open-market operations. These operations entail purchasing and selling government debt on the open market. The money supply is increased when the Fed buys government bonds, ceteris paribus.
What is the Federal Reserve’s motivation for inflation?
Some countries have had such high inflation rates that their currency has lost its value. Imagine going to the store with boxes full of cash and being unable to purchase anything because prices have skyrocketed! The economy tends to break down with such high inflation rates.
The Federal Reserve was formed, like other central banks, to promote economic success and social welfare. The Federal Reserve was given the responsibility of maintaining price stability by Congress, which means keeping prices from rising or dropping too quickly. The Federal Reserve considers a rate of inflation of 2% per year to be the appropriate level of inflation, as measured by a specific price index called the price index for personal consumption expenditures.
The Federal Reserve tries to keep inflation under control by manipulating interest rates. When inflation becomes too high, the Federal Reserve hikes interest rates to slow the economy and reduce inflation. When inflation is too low, the Federal Reserve reduces interest rates in order to stimulate the economy and raise inflation.
What can the Federal Reserve do to bring inflation under control?
Interest rates are the Fed’s major weapon in the fight against inflation. According to Yiming Ma, an assistant finance professor at Columbia University Business School, it does so by determining the short-term borrowing rate for commercial banks, which the banks subsequently pass on to consumers and businesses.
This rate affects everything from credit card interest to mortgages and car loans, increasing the cost of borrowing. On the other hand, it increases interest rates on high-yield savings accounts.
Higher rates and the economy
But how do higher interest rates bring inflation under control? By causing the economy to slow down.
“When the economy needs it, the Fed uses interest rates as a gas pedal or a brake,” said Greg McBride, chief financial analyst at Bankrate. “With high inflation, they can raise interest rates and use this to put the brakes on the economy in order to bring inflation under control.”
So, what does Larry Summers have to say about inflation?
Former Treasury Secretary Lawrence Summers argues, “It’s evident that inflation is considerably contributing to distrust in institutions and pessimism about the future.”
What is the source of inflation?
They claim supply chain challenges, growing demand, production costs, and large swathes of relief funding all have a part, although politicians tends to blame the supply chain or the $1.9 trillion American Rescue Plan Act of 2021 as the main reasons.
A more apolitical perspective would say that everyone has a role to play in reducing the amount of distance a dollar can travel.
“There’s a convergence of elements it’s both,” said David Wessel, head of the Brookings Institution’s Hutchins Center on Fiscal and Monetary Policy. “There are several factors that have driven up demand and prevented supply from responding appropriately, resulting in inflation.”
Is it true that expanding the money supply causes inflation?
When would an increase in the money supply not result in a rise in inflation, according to a reader’s question?
- Inflation is caused by increasing the money supply faster than real output grows. Because there is more money pursuing the same quantity of commodities, this is the case. As a result, as monetary demand rises, enterprises raise their prices.
- Prices will remain constant if the money supply grows at the same rate as real output.
Simple example of money supply and inflation
- The output of widgets increased by 20% in 2001. The money supply is increased by 20%. As a result, the average widget price remains at 0.50. (zero inflation)
- In 2002, the output of widgets increased by 16.6%, and the money supply increased by 16.6%. Prices are unchanged, with a 0% inflation rate.
- In 2003, however, the output of widgets increased by 14%, while the money supply increased by 42%. There is an increase in nominal demand as the money supply grows faster than output. Firms raise prices in reaction to the increase in demand, resulting in inflation.
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
Is the government in favour of inflation?
The Federal Reserve usually sets an annual rate of inflation for the United States, believing that a gradually rising price level makes businesses successful and stops customers from waiting for lower costs before buying.