by Raymond J. Keating –
Many questions naturally have arisen given the recent inflation spike.
Consider, for example, that the latest Consumer Price Index (CPI) report noted that inflation ran at a hot 5.0 percent over the past year. Things were particularly heated over the past four months, with inflation running an annualized rate of better than 7 percent. That’s deeply troubling, to say the least.
Source: Federal Reserve Bank of St. Louis, FRED
But let’s take a moment to review some basics on inflation, and then take a look at our current situation.
First, what exactly is inflation? Quite simply, it’s an ongoing increase in the general price level, measured as the percentage increase in a broad index of money prices.
In the U.S., one of the most-often cited inflation indices is the CPI, which is a price index of a representative basket of consumer goods. Other inflation measures include the GDP (or gross domestic product) price deflator, and the personal consumption expenditures price index. No matter the index chosen, the effect of inflation is to reduce the purchasing power of a currency, such as the U.S. dollar. That is, inflation means that a dollar tomorrow is worth less than a dollar today. In that sense, inflation often is referred to as a tax.
Second, what causes inflation? Many ideas are kicked around among economists, the media, politicians and businesses, but the symptoms or manifestations of inflation are often confused with the actual causes of inflation. Ultimately, inflation is a monetary phenomenon. That is, inflation results from growth in the money supply outrunning the growth in the demand for dollars. A classic way to put it is that inflation results from “too much money chasing too few goods.”
So, it follows and must be noted that inflation is not generated by too much economic or employment growth. Unfortunately, though, that’s how many “experts” speak of inflation, such as the economy “overheating.” Therefore, fighting inflation does not mean fighting economic growth. Quite the contrary, economic growth works against inflation. After all, if inflation is about “too much money chasing too few goods,” then producing more goods is anti-inflationary
It’s also important to understand that prices are always fluctuating in an economy when it comes to particular goods and services. So, the price of food could be on the rise, but inflation could be low. Inflation is not about changes in the prices of individual goods, or relative prices. A relative price is the price of a good relative to another good. Instead, again, inflation is an ongoing or persistent rise in the general price level.
That takes us to another measure that often gets attention, i.e., inflation less food and energy prices. The idea here is that since food and energy prices often are volatile from month to month, factoring these out gets one to “core inflation.” But core inflation simply is not inflation. Why? Because, again, inflation is an ongoing increase in the general price level. It’s not a rise in the prices of certain goods and services.
Third, what’s the history of inflation in the U.S.? Well, very briefly, inflation was generally low and stable when the dollar was linked to gold. But once that anchor began to be cut loose in the late 1960s and fully in 1971, inflation ignited, and ran extremely hot. For example, from 1968 to 1982, annual inflation averaged 7.4 percent. That compared to an average of 1.5 percent from 1952 to 1967.
Fortunately, inflation generally calmed back down post-1982, averaging 2.6 percent from 1983 to 2020. The Federal Reserve proved able to regain control over monetary policy with an increased focus on price stability. For good measure, as I have argued before, the reality about the dramatic decline in inflation in the 1980s was that it was just as much about pro-growth tax, regulatory and trade policies established under the leadership of President Reagan as it was about then-Federal Reserve Chairman Paul Volker tightening monetary policy. Again, economic growth is anti-inflationary. So, the policy agenda of the 1980s of pro-growth tax, regulatory and trade policies, combined with monetary policy focused on price stability, resulted in faster economic growth and disinflation.
But questions have swirled around monetary policy and what it might mean for inflation since the recession worsened and the credit meltdown hit in 2008. In the late summer of 2008, the Federal Reserve began running monetary policy so loose that there was no precedent in U.S. history. And the Fed has continued to do so – even loosening further during the pandemic economy. Specifically, for almost 13 years, the Fed has expanded the monetary base, which is currency in circulation plus bank reserves, in a previously unimaginable way. That has created uncertainty as to how this might eventually play out. Indeed, whenever a monetary authority, such as the Fed, shifts its focus away from price stability, the results range from increased questions about inflation to inflation taking hold and accelerating. It also must be noted that, as the old saying goes, once the inflation genie escapes from the bottle, it’s very hard to push it back in.
But the U.S. has been fortunate – for myriad possible reasons – that inflation had remained tame into very early 2020.
Fourth, what about inflation today? With the onset of the pandemic and related government shutdowns, prices took a dive in March, April and May 2020; spiked up in June, July and August; and then settled down some for the following five months into January 2021. Since then, however, over the last four months, as noted earlier, inflation has been running at a better than 7 percent annualized rate.
With an economy coming out of pandemic-related shutdowns across most industries to varying degrees, the loss of millions of small businesses and jobs, a dramatic shift in how countless businesses operate, significant and ongoing supply chain issues, new expectations among many workers as to how they wish to work, and unprecedented government subsidies to those not working, increases in costs for businesses and in prices for consumers are not exactly surprising. There are tremendous changes and tumult occurring in the economy.
But is this the start of a significant bout of inflation, or is it merely transitory given the challenges faced as the economy continues to claw back? That’s the big question, and there is no clear cut answer. As I have noted before, the best case scenario is that this will be transitory, as the recovering economy struggles to get production, operations, supply chains and employees back to something close to normal. The market will adjust, responding to price signals, and growth will advance while inflation calms down. That points to stormy waters for small businesses in the short run.
But then there is the ugly scenario in which high inflation takes hold, which creates uncertainty and increased costs, including for small businesses, such as higher interest rates, rising input prices, and obviously, a diminished value of the dollar. Also, higher inflation goes hand in hand with increased price volatility, further clouding decision making.
Unfortunately, the loose money that the Fed has been running for years now increases the risks that this inflationary moment will not be transitory. The Fed should always be focused on running monetary policy with the goal exclusively being on maintaining price stability. But that has not been the case. So, given the recent inflation spike and 13 years of loose monetary policy, the Federal Reserve needs to get serious about reining in that loose money. For good measure, recalling our points about growth working against higher inflation, anti-growth policies being pushed, for example, by the Biden administration, such as higher taxes, increased regulation, and a vast expansion in federal spending, must be rejected.
The policy mix always matters, but most especially during deeply uncertain times. Get the policy mix right, and chances will increase that this recent bout of inflation will in fact be transitory, with market players responding to price signals and getting the economy settled onto a path of stronger growth and low inflation. But if government gets the policy mix wrong, and impedes the supply-side of our economy, that is, raising the costs of entrepreneurship, investment and work, then the risks for the worst case scenario of slow growth and high inflation – i.e., stagflation – increase.
Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.