Recent reports indicate that inflation is at its highest level since last October. According to reports, the economy is “heating up,” a phrase that has become synonymous with rising price inflation. Maybe the Meredith College Cinderella Project can help.
In an effort to make sure that more budding Cinderellas are outfitted for their senior proms, Meredith College is collecting used prom dresses and distributing them, free of charge, to young ladies who qualify. Donated dresses? What’s that got to do with reducing inflation, you ask? If you subscribe to the Keynesian spending-driven theory of inflation, donated dresses, which reduce the market demand for prom attire, are one way to reduce upward pressure on consumer prices. Are higher prices the same thing as inflation? Not exactly, though price levels and inflation are closely related.
The Federal Reserve, our central bank, is responsible for regulating the U.S. money supply and for watching employment and inflation trends, among other economy-wide measures. Media reports about inflation suggest that while the Fed can address the inflation problem by adjusting interest rates, too much spending causes inflation in the first place.
Yes, and no. Yes, the Fed aims to dampen spending and borrowing when the economy shows evidence of rising inflation—”heating up” in the misleading vernacular. But no, too much spending is not the cause of inflation. The cause of higher economy-wide prices is Fed-created credit, and the additional money this pumps into the economy.
Money and credit creation are part of the Fed’s monetary policy power. The direction and size of money supply changes are mainly the charge of the Fed’s Open Market Committee. New money and credit increases bank lending and facilitates extra spending in the first place. Without the Fed-created additional dollars, prices could not increase across the economy.
Prior to June 2004, the Fed spent two years lowering the interest rates that sent new credit and spending power into the economy. That policy was designed to stimulate economic activity and employment, to move a sluggish economy forward. It also started the ball rolling toward higher prices. With new or bigger incomes, consumers and producers spent and invested the extra money. When everyone has more to spend, though, market prices are bid up—the result of inflating the money supply.
After continuously reducing the discount and federal funds rates, from January 2001 to June 2003, the Fed now finds that it needs to reverse course to try to keep prices from rising too fast. A more restrictive credit policy has been enacted since June 2004, including the latest and seventh consecutive interest rate hike.
Since inflation is not caused by “too much,” business or consumer spending, telling folks not to spend in the interest of reducing inflation will not curb a rising price level. (Not to downplay the importance of the spending vs. saving decision, which makes a great deal of difference in personal financial security.)
Less spending, on its own, doesn’t get to the root cause of inflation. But reducing the availability of Fed-created credit, the policy the Fed is now pursuing, will stem the flow of new dollars into markets, reduce demand for goods, and ease the upward pressure on prices. Although spending is a necessary part of the inflation process, it is itself a consequence of the Fed’s easy money policies.
Reversing an “easy money” policy can create unpleasant transition effects, such as additional unemployment, in labor and resource markets. The Federal Reserve’s latest report to Congress did not anticipate these effects, but as “easy credit” disappears, consumers and producers will undoubtedly make purchasing and hiring adjustments, as the recent rise in the NC jobless rate shows.
The moral of this story: only Cinderellas get a free lunch here.