Headlines have announced inflation is back, and this certainly appears to be accurate. In 2004, retail prices rose 3.3 percent, up from 2.3 percent in 2003 and only 1.6 percent in 2002. In the first three months of 2005, the retail inflation rate is running at an annual rate of 4.3 percent.
The jump in inflation is not caused by rising oil and gas prices alone. Taking out food and energy prices, retail inflation still climbed during the past two years.
Of course, any business person or store manager will point to the source of inflation—rising costs of doing business. The restaurant owner will cite higher costs for food, labor, and electricity. The builder will argue he has to pay more for lumber, nails, and drywall. And the painter will say increased costs for paint, brushes, and white shirts force her to charge more for painting services.
These experiences make it seem as if there are multiple causes of inflation, and from the point of view of individual companies, there are. But this still leaves a larger question unanswered—what gets the whole process started?
Economists have a simple answer—money! The economic workings of higher inflation really can’t get started without being prompted by too much money being available for people to spend.
Here’s what I mean. Say the total quantity of everything we buy—cars, gas, dental services, clothes, etc.—is increasing by 5 percent each year. Now say the money we have available to purchase these things is also increasing by 5 percent each year. In this case, there is a balance between the increase in production and the increase in spending, and as a result, prices don’t change, which is the same as saying there is no inflation.
But now what if the available amount of money is increasing by 8 percent each year? This means people are trying to increase their purchases of products and services by 8 percent, but the production of these products and services is rising by only 5 percent. So people are trying to buy more than is available (economists say demand is increasing faster than supply), and so something has to give.
What gives is prices. Rather than remaining stable, prices will rise by the difference between spending growth (8 percent) and production growth (5 percent), which is 3 percent. So in our example, the inflation rate rises from 0 percent to 3 percent.
A long time ago, an economist summarized it this way: Inflation results from “too much money chasing too few goods.” Sustained higher inflation rates can’t be maintained unless they are supported by excessive money growth.
Where does this faster money growth come from? It comes from the country’s super-bank, the Federal Reserve. The Federal Reserve effectively controls how many dollars are printed and released into the economy.
So why are we having higher inflation now? It’s actually part of a pattern. Three and four years ago the economy was wobbly with a recession and very slow job growth. A standard tool the Federal Reserve uses to perk up the economy is to put more money into consumers’ hands. In fact, during much of 2001 and 2002, the Fed increased the supply of money by a rapid 10 percent rate.
Some say the Fed’s tactic worked because the economy is doing much better now. But on the downside, the Fed’s actions have meant a lot of dollars are chasing after a smaller amount of products and services, and so, bingo, we have higher inflation. (Also, as an aside, the Fed’s policies have contributed to the decline in the value of the dollar against foreign currencies.)
Fortunately, the Fed is now off its money binge, with the money supply now rising at about 5 percent a year. This means we’ll probably see the inflation rate moderate in a year or too. But in the meantime, we’re paying for the monetary boost of a few years ago with higher prices today. This has led some economists to wonder whether the Fed ought to be replaced by a computer designed to feed the economy a steady supply of new money!
Michael L. Walden is a William Neal Reynolds distinguished professor and extension economist at North Carolina State University and an adjunct scholar with the John Locke Foundation.