What will the Fed be able to do as inflation rises?
In its July 9 Monetary Policy Report, the Federal Reserve tells us not to worry about inflation.
“Some of the strength in recent 12-month inflation readings reflects the comparison of current prices with prices that sank at the onset of the pandemic as households curtailed spending—a transitory result of ‘base effects.’ More lasting but likely still temporary upward pressure on inflation has come from prices for goods experiencing supply chain bottlenecks, such as motor vehicles and appliances,” the report states.
Stories of jobs going wanting while potential workers wait out the end of unemployment benefits add to the characterization of upward price pressure being temporary — the higher wages necessary to attract these workers back will give way once the compensation for not working evaporates.
This is very reassuring, except for two points.
The first is that economics is a social science not a physical science. The Fed report itself recognized that what people believe about inflation’s likely course becomes a self-fulfilling prophecy. This is for the obvious reason that if a manufacturer or bank expects price levels to rise by, say, 3%, then the price of the good or interest rate on a loan must increase by 3 percentage points if the seller or lender is to stay even.
The Fed reported it was monitoring inflationary expectations, but that is not the same thing as building credibility that the Fed will act if those expectations do rise. The monetary medicine is severe, and for that reason, few believe the Fed will apply it.
We last saw this in 1979 to 1983, when Fed Chief Paul Volcker increased interest rates over which the Fed has direct control. Mortgage rates rose to above 16%. Volcker induced a recession that defeated the reelection of the President Jimmy Carter, who had appointed him to the position.
It took over four years, with serious unemployment, and the election of a new president, to convince Americans that inflation had been tamed. No one believes this Fed is inclined to apply such medicine, especially so soon after the COVID-19 recession.
Under Chairman Jerome Powell, the Fed has telegraphed instead that its mission is to achieve full employment — hugely desirable, of course, but not reassuring to those who doubt Powell’s will to imitate Volcker.
The second concern is that, under Powell, the Fed has been printing money as never before, responsive to the COVID-19 downturn. From January 2020 to May 2021, the latest date for which data are available, the measure of money in our economy has risen by 32%. By comparison, in the seventeen months prior to that period, money rose only 8.8%. That amount of new money does not dissipate; it stays in the economy.
The price level is directly related to the amount of money in society.
A classic thought experiment in an introductory macroeconomics course is to ask what would happen to prices if the government were to drop $20 bills from helicopters over U.S. population centers. Obviously, prices would rise, unless one of two other things happened simultaneously: economic output (GDP) increased in the same proportion as the amount of money in circulation, or the use of money to buy goods dropped.
This “equation of exchange” was first posited by the great American economist Irving Fisher in 1911 and became the basis for the quantity theory of money promoted by Milton Friedman.
COVID-19 did, indeed, decrease the use of money as fewer purchases were made (the drop was about 20% over the same 17-month period), and output dropped as well. As we recover from the pandemic, however, the use of money has returned to its traditional levels. And, while the economy is returning, the rebound of real GDP has not matched the increase in the money supply.
The result, according to textbook economics, must be inflation equal to the difference. Nothing in the Fed’s July 9 report refutes this. The Fed simply says it hasn’t happened. Yet.
Tom Campbell is a professor of economics and a professor of law at Chapman University. He served five terms in the US Congress, including on the Joint Economic Committee. He left the Republican Party in 2016 and is in the process of forming a new party in California, the Common Sense Party. Milton Friedman was Campbell’s faculty advisor for his Ph.D. in economics.