The July inflation number that came out Wednesday morning gives me a chance to soothe any fears that inflation or monetary policy is behind our weak growth in the last thirty years or indicates an ominous future.
Understanding the impact of inflation and monetary policy will help us not be distracted from the fiscal policy issues that actually endanger the financial security of many.
A large portion of people struggling financially blame (or perhaps have been trained to blame) their hardship on inflation or taxes or the government in general. The problem is more multifaceted than that.
If you can’t get the car in the garage because of hundreds of cardboard boxes: is the problem the garage is too small or too much clutter? Similarly if you are struggling financially are expenses too high or is income too low? What if your income was 43% higher? Would that help?
Last year the bottom 50% of society had 13.3% of the income. If the bottom 50% still got the 19.1% of income they got in 1980 they on average would have 43% more income.
From the Fiscal Power perspective the problem is that fiscal policy i.e. government taxes and spending has enabled the reward for existing wealth to soar by squeezing the reward for work.
It can be made to sound scary that Inflation ticked up in June to the highest level since 2007. The slight down-tick in the July rate may or may not mean the highest inflation rate is over.
However, the rate of inflation does not have a statistically significant correlation with the share of the pie going to workers or the bottom 50%. What little correlation there is actually suggests labor gets a bit larger share relative to capital the year after inflation is around 5%.
The 5% move is big enough to spot in a 270 year chart of inflation.
The last wrinkle on the chart curls noticeably higher. A year ago the best fit inflation rate from 2007 was 1.64% and rounded down. Now it’s 1.66% and rounds up to 1.7%. Before I show that’s not a big enough change to worry about. Let’s talk about this chart a bit.
The Federal Reserve was created in 1913. Before this we had no central bank in charge of monetary policy. There were periods of rapid inflation and deflation but there was no long term upward trend in the price index. The creation of The Fed coincides with a sustained upward trend in the price index.
Now before you go thinking inflation is bad consider that in the 59 year period where inflation trended at 4.3%, real GDP per-person was growing at 2.6% whereas in the period prior to The Fed real growth per person trended at 1.4%.
My first economics professor at Vanderbilt estimated a 1% rate of inflation was best for growth. Over the decades since I’ve worked on my own estimate and think the optimal is about 1.5% where the two red fitted lines meet in the chart below.
This chart covers all the seven year periods since The Fed was created. The seven years with the lowest inflation 1927–1933 had deflation running at 4.4% and the growth per person running at -4.1%. The two 7-year periods with the highest inflation ended in 1920 and 1980.
The correlations shown in the two red line segments suggest inflation does harm growth, but that deflation is about four times worse.
We’ve had 5.4% inflation over the last 12 months; this isn’t far out of the optimal range and the chart suggests it is about as hard on growth as inflation at 0.7%. Inflation at 0.7% doesn’t warrant scary headlines and neither should inflation at 5.4%.
Part of the reason economic growth has been much faster since 1933 may be The Fed became willing to take extremely bold measures to prevent deflation. I haven’t heard anyone else claim this, but after the 43 month recession ended in 1933 I think The Fed became extremely averse to deflation. The second recession in the Great Depression only lasted 13 months and had much less deflation than most prior recessions.
Several central banks including our Fed aim for a 2% inflation rate. I think they know the growth optimizing rate is a bit lower and aim for margin of safety. When a recession comes it typically cuts inflation a couple of percentage points. Having a margin of safety gives them a chance to avoid destructive deflation.
Through most of The Fed’s existence its mandate was full employment. In 1978 it got a second mandate of stable prices. After inflation peaked in January of 1980 the long term rate of inflation has trended down toward the growth optimizing level. The Fed has done an increasingly good job at monetary policy and making prices more stable. The recent spike is quite mild compared to the 1970s
Probably the only time we would need to pay attention and take action is if there were politicians trying to gain power over The Fed or wanted to dismantle it. The Fed has the power to buy Treasury bonds directly from the Treasury. In the last couple of decades they call this quantitative easing or QE. This is the closest thing our system has to the government printing money to pay its bills. The decision to do this by experts in the interest of full employment and stable prices is dramatically safer than politicians being able to print money.
Hyper inflation that ruins economies, such as during the Wiemar Republic in Germany, comes when politicians in interest of their next election keep spending high, keep taxes low and can print money to cover the difference.
We need to keep the power to print money out of the hands of politicians.
Hopefully, I have allayed any fears about inflation and monetary policy so in the next post we can get back to talking about the fiscal policy moves that can help build an economy that satisfies everyone’s needs.