Targeting Inflation

In his Jackson Hole speech several weeks ago, Fed Chairman Jerome Powell reiterated that the Fed would maintain a 2% target for inflation. While CPI sits around 3.7% year over year, with some indication that it might continue to creep up due to energy costs rising, it might come as a surprise that Powell’s rhetoric isn’t easing up yet. However, calls for a higher target are starting to appear, and will likely continue to appear with increasing frequency. Economist Jason Furman wrote an op-ed in the WSJ on August 20th arguing for a 3% target, and fellow fiat apologist Paul Krugman’s tweet of support for the idea wasn’t far behind.

This all begs several questions—why was 2% the right number, what is the tradeoff we get by moving the target to 3%, why the heck do we need inflation to begin with, and even the basic “what causes inflation?”

I hope Joe’s post above helps you understand what causes inflation. It isn’t too complex despite what talking heads may say. “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Thanks Milton Friedman. And this makes sense! If there was only a million dollars in the world, and you then doubled that to two million dollars while keeping the amount of goods the same, you’d see prices of goods rise. If I were a vender, there would be more demand for my scarce goods, giving me the ability to raise prices and reflect the truth that my goods are scarce. And we got to see that in 2020—present (some will no doubt point out that constrained supply chains also lead to price increases. This is correct, but if the cause of the price increases is only supply chains, then once those supply chains are unconstrained, prices should fall back down to normal levels. If the cause is the creation of new money, well, then, you are stuck at permanently higher price levels ?).

I want to dwell on this concept of money creation. We tend to think of inflation as a price you pay to play the game, or a given. I think we need to reframe our minds. Think of it this way. Let’s say you own stock in a publicly traded company. This company decides to issue new shares and doubles the number of shares in existence. Furthermore, the company doesn’t intend to do anything productive with your shares. What happens to the value of your shares? You’d be right if you said that the value just halved. The same thing happens with money. When new money is created, the price of goods will adjust over time, so the money you have will be able to buy less, UNLESS you happen to get that new money first. This is called the “Cantillon effect.” Worth looking up. Also, semi-relatedly, did you know that 5 of the wealthiest 10 counties in the US are around DC? Now you do.

(If you’re curious about how money is created, see this thorough article by Lyn Alden)

If you own scarce goods (land, commodities, shares in strong companies that are responsible with new share issuance, rare art), you can mostly avoid the financial pinch (societal and moral degradation is a separate matter and I’ll discuss that some other time). But if the money in your bank account and the currency you are paid in is all you have to your name, then this inflation is painful. Inflation harms the most vulnerable economically.

Oh, it also creates income disparity in our society, which is a long-term threat to democracy.

As to the question “why do we need inflation?” Powell was asked this very question in an interview and struggled to give a coherent response beyond "well that’s what we’ve always done." Which isn’t quite true—2% was formalized in policy only in 2012, though was the unofficial target under Greenspan in the 90’s (various internet sources suggest annual inflation since 1914 has been somewhere between 3.3% to 3.8%, but note that that is based on CPI which likely understates the true inflation that the average American has experienced).

When questioned, many people will tell you that we need some inflation to support growth. As the population grows, we need more money for more people. Economists will remind you that inflation might help cushion economies from recessions—after all, spending money is what leads to growth, right? Isn’t that what GDP measures? Isn’t that how we got out of the Great Depression?

The above logic is deeply flawed. While spending might lead to economic growth, the definition is too narrow. If growth is understood as an increased and/or more efficient production of real goods and services, it becomes clear what one spends on matters. Buying potato chips is fine, but investing in a production line that more quickly produces potato chips leads to real growth. So all spending is not equal. And remember, with inflation, it’s Uncle Sam directing where the money goes. Sadly Sam is usually a terrible capital allocator, and we’re all poorer for it. ?

Additionally, it’s not the amount of money that makes someone wealthy—it’s the amount of goods and services that one can buy that really matters. Money is a claim on the goods of society, and the holder of money presumably has said money because of value created for society (what can I say, I am an optimist). Let’s go back to the example of there only be $1 million dollars in the world, and suddenly increasing it to $2 million. Did society just get wealthier? NO. Not if the amount of goods and services remained the same. I can’t drive my money to work, I can’t eat my money for lunch, and I can’t write this note on money (remember my handwriting is illegible). I get this is counterintuitive; for most of us the number in the bank account is the scoreboard.

What’s the alternative? Well, the money in your bank account could GROW in purchasing power. This could occur with “hard money” in a deflationary economic system, one with a fixed money supply that couldn’t be inflated. Actually, doesn’t sound too bad. Under a gold standard, we weren’t too far away from that (historically gold inflates at 1%-2% annually). Nowadays you have to 1) earn money and 2) know how to properly save money, (i.e. invest wisely), just to stay afloat. Deflation tends to be associated with depression, but if you blow up a balloon too much (inflation), eventually balloons burst (rapid deflation). Instead, deflation wouldn’t have to resemble the Great Depression, it would likely be very gradual, dictated by increases in technology and productivity. ?

If this sounds bizarre or far-fetched, I get it. But I hope you’ll at least agree that it’s worth asking the question “why is inflation an economic given?”

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