Fed’s flirtation with inflation brings consternation

Art Buchwald was a humorist, a Pulitzer Prize-winning columnist and a former Marine. He also understood economics better than most people — and certainly most economists. His economic analysis may have lacked the elegance and stilted vocabulary required for academic stature, but he had something else: most of the time he was right.

In one of his trenchant observations, he wrote that, “If both inflation and deflation are bad for the country, obviously what we need is flation.”

Buchwald had lived through periods of falling prices and declining output, rising prices and booming economic activity, and even something called “stagflation,” where prices soared even though the economy was stagnant. All of these things are bad for the economy and bad for us, but here we are in the second decade of the 21st century and economists don’t seem to get the message. They are in love with inflation.

In its charter from Congress, the Federal Reserve’s duties include, “conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices and moderate long-term interest rates.”

Current economic theory inserts a conflict into the mix with the result that it is now a matter of orthodoxy that the three goals — maximum employment, stable prices and strong economic growth — don’t play well together.

The famous Phillips Curve shows the relationship between unemployment and inflation and indicates that there is a “natural rate” of unemployment in an economy and adding more jobs beyond that point will cause rapid inflation. The future is always different from the past, though, it isn’t easy to time Fed actions to take effect before inflation is fully wound up and takes over everyone’s expectations.

The money supply is an even more direct cause of inflation — too much money chasing a relatively fixed amount of goods and services — but presents a different set of problems for economic policy makers. The fundamental equation of the quantity theory of money seems logical: The money supply times its velocity (how many times it changes hands in the economy) equals the price level times the output.

The equation is actually more of a notational identity, though, and it is far from a perfect basis for managing the money supply. One economist described it as “one equation with three unknowns” and pretty much nailed it.

Theoretical issues aside, the practical problem for the Federal Reserve is that the money supply is not a fully controllable variable. In our financial system the Fed does not create the bulk of the money supply; it creates the setting that allows commercial banks to create money by making commercial loans. That is a subject area in its own right, but the fundamental idea is this: When the loan officer signs that loan agreement, it creates a deposit in the bank that the borrowing business can then spend. It’s real money that didn’t exist before the loan officer picked up that pen and put his or her name down on the paper.

The Federal Reserve can slow down the growth in money supply by reducing the amount that banks can lend or by making it more expensive for banks to lend money. The question is: When?

While very much aware of the economic theories, the Fed takes a very practical approach to its policy-making: It sets targets for unemployment and for inflation. When those numbers are too high, it moves to cool the economy down a little.

Until very recently, the Federal Reserve had announced very specific target numbers — 6.5 percent unemployment and 2 percent inflation — but the new Fed chairwoman, Janet Yellen, says that the policy maker will now use a broader mix of variables to determine its rate and money supply actions. Exactly what that mix contains, though, and whether it will be publicly disclosed are not known.

The inflation target is a particularly important, even critical element for the public to know. Policy makers have become infatuated with the idea that inflation is necessary for sustained economic growth — a textbook case of confusing cause and effect. It would be comical, like players’ lucky socks or coaches’ unlaundered sweaters, except that inflation isn’t funny and is certainly not something to play around with.

Over a period of twenty years, for example, even a relatively modest inflation rate of 2 percent, the last known Federal Reserve target, would reduce the purchasing power of each dollar by a third. It’s like taking a pay cut every year. No wonder our economy gets out of balance.

We need more job opportunities and we need economic growth. We do not need state-sponsored inflation. Buchwald was right. What we need is flation.

James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Herald Business Journal.

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