The topic of inflation comes up a lot around here… but now it’s become downright inescapable, like a head cold that hangs on forever no matter what you do. With gas now past the $5 mark nationwide – a dystopian prospect only six months ago – the Federal Reserve has finally brought out the big guns of steeper rate increases.
But inflation is a very complex phenomenon, and their chances of success depend in large part on what’s primarily driving it. So it’s hard to say whether their new offensive will do the trick. Doesn’t mean we can’t try though – time for some pre-game analysis.
Monetary inflation: is it a currency problem?
This may go without saying, but a major cause of inflation is an increase in the amount of currency floating around an economy. This is known as monetary inflation: the more dollar bills get into circulation, the less purchasing power they have individually. Pretty simple.
It may also go without saying that the Federal Reserve has a fair bit of control over this type of inflation. By raising or lowering banks’ borrowing rates, the Fed encourages people to save or spend, respectively – thus decreasing or increasing (respectively) the amount of free-flowing cash.
So to the extent that monetary inflation is the problem right now, the Fed’s strategy of increasing rates could do the trick. And we all know it’s a major cause of the problem right now… but unfortunately it’s not the only one.
Consumer price inflation: is it a supply problem?
The most obvious sign of inflation is when consumer goods get more expensive across the board – but this isn’t always caused by monetary inflation. So economists treat it as a separate phenomenon; namely, consumer price inflation.
Suppose, for example, that shipping operations get choked by foreign conflicts and/or labor disruptions (crazy, I know). So goods are still being produced, but there’s effectively a scarcity because it’s much more difficult to get them to people. Boom – stuff gets more expensive across the board, and money supply had nothing to do with it.
Conversely, an increase in the money supply doesn’t itself guarantee inflation. If an economy’s productivity keeps pace with higher cash flow, then there’s more stuff to go around and prices don’t rise as much as they would otherwise.
Unfortunately, we’ve got tons of extra cash and supply chain snarls right now, without increased productivity or slacking demand to offset either. While the Fed can attack the first problem, it can’t really do anything about the second.
Asset price inflation: is it a distribution problem?
All that said, there’s one other type of inflation we should consider. Consumer goods aren’t the only thing vulnerable to artificial price increases – investable assets are too. But asset price inflation is a very different animal from consumer price inflation, and can even be inverse to it.
As analyst Lyn Alden puts it, if the central bank were to print a trillion new dollars and distribute them to the richest 100 Americans, those dollars would likely be invested rather than spent. This would push up the price of assets like gold, stocks, real estate etc. But if that money were instead distributed to non-millionaire Americans, far more of it would go to consumer goods – thus pushing up those prices.
Obviously, the Fed doesn’t issue $10 billion checks to the richest Americans. If anything, we saw the opposite scenario during the pandemic. The point is that asset inflation is more likely when wealth is concentrated in the upper classes, while consumer inflation is more likely when it’s more evenly distributed.
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Surprise – it’s all three!
Over the past couple of years, we’ve seen a huge increase in monetary supply accompanied by inflation in both consumer goods and investable assets. The weird thing is that the latter is finally undergoing a major correction (painful though that may be), but the former is not. Why is that?
Alden goes on to note that wealth concentration has greatly increased in the past few decades, and that low interest rates also contribute to asset inflation. In view of both those facts, last year’s huge stock market rally makes a lot of sense. And meanwhile, the broad flood of stimulus cash also explains spiking consumer costs.
It’s oversimplified, but here’s a rough illustration of how of productivity, wealth concentration and money supply tend to interact, with inflation becoming more pronounced as you move farther down the triangle:
Like monetary inflation, the Fed can exercise some control over asset inflation by raising rates. In fact, this year’s stock market downturn indicates they have successfully done so. But at the same time, consumer price inflation is often driven by factors outside the Fed’s control.
And that, in a nutshell, is why the outcome of their strategy is so uncertain right now.