Is the Fed an Inflation Fighter or Creator?

After reading this article by Frank Shostak, I was reminded of the first time I learned about the ‘double-meanings’ that riddle modern law, contracts and legalese. This is when words no longer have dictionary definitions, but instead carry specially defined meanings created solely for the purpose of misleading the common reader. Mr. Shostak taught me that the true meaning of ‘Inflation’ has been replaced by a common popular belief. We seem to have forgotten (or never really learned) the true meaning of ‘Inflation’; it is the act of increasing the amount of paper currency into public circulation which in turn causes a rise in consumer prices and a devaluation of the currency–as opposed to simply a rise in consumer prices (which is easily confused because the word ‘inflation’ implies ‘to rise’). It seems odd, but when we are told by the government that prices have gone up because of inflation, it isn’t questioned as to why. Who caused this inflation and how? Why must general consumer prices and costs of living rise every year? Is it because people are just greedy or maybe demand is significantly outpacing supply? Read on and get some answers!

by Frank Shostak
Tuesday, October 25, 2005
As posted on Lew Rockwell

Every few days, a senior Fed official expresses concern regarding the effect of high gasoline prices on inflation. These comments are always phrased in the way a meteorologist would report on the weather, as if the phenomenon in question is an act of nature. Even stranger, these statements imply that only the Fed can hope to save us from this natural disaster.

To invoke another metaphor, this is like the cook who bakes?a poison pie and then arrives on the scene of grave sickness, claiming to be the medic with the antidote.

It is the Fed that creates, not cures, inflation. The surest way to stop it is to stop the printing presses?something that a government with massive debt and the desire to sustain a boom is not likely to do.

The Fed?s latest warnings began on September 5, 2005, when the retail price of gasoline climbed to $3.069 per gallon?an increase of 72.6% from early January of this year.

They believe that the decisive factor in the setting of an inflationary spiral is people?s inflationary expectations. This causes workers?to press for higher wages. Businesses try to recoup these wage increases by pushing the prices of goods and services higher. This ignites inflation, or so it is believed.

On October 19, 2005, the President of the Dallas Federal Reserve, Richard Fischer, said at a luncheon in Houston, “I will not waver from advocating policy that discourages expectations of higher core inflation. The object will always be to keep inflation at bay, so that the American business machine can keep on humming.”

It is inflationary expectations, so they believe, that keep inflation going once inflation is triggered. Also, once expectations are set in motion it is not easy to get rid of them.

On October 20, 2005, the President of the St. Louis Federal Reserve, William Pool, told reporters, “If confidence in price stability starts to erode and inflation expectations begin to develop, it can be painful and long to reverse those expectations. Undoing inflationary expectations can be a matter of a couple of years.”

Consequently, he believes that the Fed must raise interest rates enough to keep inflationary expectations well contained. He also added that, “if we were to end up overshooting on the federal funds rate target on the high side and we found that the economy slowed more quickly than anticipated then cutting rates could restore growth relatively quickly.”

On October 21, 2005, the President of the Federal Reserve Bank of Richmond, Jeffrey Lacker, told reporters that he is increasingly worried about inflation and the prospect that higher energy prices will filter through into other goods. “My concern about inflation is distinctly higher now. We are facing the prospect now of the possibility of the energy price surge passing into core prices.”

The latest data gives credence to the Fed officials? concerns. The rate of growth of the producer price index which excludes energy prices jumped to 0.6% in September after falling 0.1% in August. Year-on-year the rate of growth climbed to 2.4% in September from 2.2% in the previous month and 1.7% in June.

Furthermore, year-on-year the consumer price index rose by a massive 4.7% in September. Additionally, according to a closely watched survey by the University of Michigan, consumers’ expectation of inflation 12 months ahead jumped to 4.6% in early October from 3.1% in August.

On account of these developments, it is believed, the Fed must show leadership and act as soon as possible against emerging inflation. Once people see that the Fed is a serious inflation fighter this will calm down inflationary expectations and will keep inflation at bay, or so it is held.

What is inflation all about?
In a market economy, money enables the goods of one specialist to be exchanged for the goods of another specialist. For instance John the baker has produced ten loaves of bread, which he has exchanged for ten dollars. He then uses the ten dollars to buy twenty tomatoes from a farmer Bob. Note that in order to acquire twenty tomatoes John had to produce ten loaves of bread first. In short, his consumption of tomatoes is fully backed up by the production of bread. Also, note that the money here is honestly earned and hence fully backed up by John?s production of bread. Or we may also say that here we have a case where something useful is exchanged for money and money in turn is exchanged for some other useful thing?something is exchanged for something else by means of money.

Let us now consider a case of a counterfeiter?call him Charlie?who instead of producing something useful has created ten dollars by means of printing these ten dollars. He then uses these dollars to buy twenty tomatoes from Bob the farmer. His counterfeiting amounts to?an “exchange” of nothing (since Charlie hasn?t?produced anything?economically?useful) for ten dollars, which is in turn?exchanged for twenty tomatoes.

Consequently, by means of money, which was created out of “thin air,” Charlie the counterfeiter can consume without any production. Note that the money here, which was created out of “thin air,” is not supported by any production of useful goods or services. Or we can also say that here we have a case where nothing useful is exchanged for money and money is exchanged for useful things?nothing is exchanged for something useful by means of money out of “thin air.”

By creating money out of “thin air,” Charlie the counterfeiter has in fact boosted or inflated the stock of money. This inflation of money in turn has enabled Charlie to secure tomatoes at the expense of a genuine wealth producer John the baker. In other words, while John the baker has contributed to the pool of funding, i.e., the pool of final goods this is not the case as far as Charlie the counterfeiter is concerned?he is consuming final goods without putting anything useful to the pool of these goods.

It follows then that the diversion of real wealth from wealth generators to non-wealth generators by means of increases in the money supply is what inflation is all about. Or we can say that inflation is about the economic impoverishment of wealth producers, which is set in motion by means of inflating the stock of money.

Through the increase in money supply, Charlie the counterfeiter adds an extra demand for goods and services without making any contribution to the production of goods and services. In short, the new money that Charlie created together with the previous money is now chasing an unchanged stock of goods.

Now, a price is the amount of dollars paid per unit of a good. Hence with more money now chasing a given amount of goods it implies that the price, i.e., the amount of dollars now paid for a unit of a good, has risen. Note that a general increase in prices here took place as a result of the inflation of the money stock.

Observe that the fall in the purchasing power of money, i.e., general increase in prices, is not what triggers the economic impoverishment of wealth generators. The trigger is the creation of money out of “thin air,” or the inflation of the money stock. A general increase in the prices of goods and services is merely the symptom of the inflation of money, i.e., the manifestation of inflation. In short, a general increase in prices reflects the fact that increases in the money supply, i.e., money out of “thin air,” have given rise to nonproductive consumption.

Note what we are not saying. We don?t say that inflation is the increase in prices caused by increases in money supply. What we are saying is that increases in money supply is what constitutes inflation.

What is wrong with the popular definition of inflation?
According to?Mises,

“Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation.”

In short, what today is called inflation is the general rise in prices, which is in fact only the outcome of inflation. Consequently, anything that contributes to price increase is called inflationary and therefore must be guarded against.

Thus a fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and therefore must be restrained by central bank policies. Some other triggers such as rises in commodity prices or workers wages are also regarded as potential threats and therefore must be always under the watchful eye of the central bank policy makers.

If inflation is indeed just a general rise in prices, why is it regarded as bad news? What kind of damage does it do? Mainstream economists maintain that general price increases cause speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources.

Despite all these assertions regarding the side effects of what they define as inflation, mainstream economics doesn?t tell us how all these bad side effects are caused.

Why should a general rise in prices hurt some groups of people and not others? Why should a general rise in prices weaken real economic growth? Or how does inflation lead to the misallocation of resources? Furthermore, if inflation is just a rise in prices, surely it is possible to offset its bad side effects by adjusting everybody?s incomes in the economy in accordance with this general price increase. However, once it is established that inflation is about the destruction of the process of wealth generation then all the above questions are easily answered.

We have seen that increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price increases as such, which is only the manifestation of this misallocation.

Moreover, the beneficiaries of the newly created money, i.e., money out of “thin air”?are always the first recipients of money, and so they can divert a greater portion of wealth to themselves. Obviously, those who either don?t receive any of the newly created money or get it last will find that what is left for them is a diminished portion of the pool of real funding.

Additionally, real incomes fall not because of general rises in prices, but because of increases in the money supply, which gives rise to nonproductive consumption. In other words, inflation depletes the real pool of funding, which undermines the production of real wealth?i.e., a lowering of real incomes.?

General increases in prices, which follow increases in money supply,?are an indication that the erosion of peoples? purchasing power has taken place. It is not the symptoms of a disease but rather the disease itself that causes the physical damage. Likewise, it is not a general rise in prices but increases in the money supply that inflict the physical damage on wealth generators.

Can inflationary expectations trigger a general price rise?
Recall that according to popular thinking, workers’ expectations for higher inflation make them demand higher wages. Increases in wages in turn lift the cost of producing goods and services and force businesses to pass these increases on to consumers by raising prices. It is true that businesses set prices and it is also true that businessmen while setting prices take into account various costs of production. However, businesses are ultimately at the mercy of the consumer who is the final arbiter.

The consumer determines whether the price set is “right,” so to speak. Now, if the money stock hasn?t risen, consumers won?t have more money to support the general increase in prices of goods and services. (Remember, that a price is the amount of money per unit of a good).

Consequently, a strengthening in inflationary expectations cannot by itself set in motion a general increase in prices. After all the realization of expectations has to go through the monetary channel. So irrespective what people?s expectations are, if the money supply hasn?t increased then peoples monetary expenditure on goods cannot increase either. This means then that no general strengthening in price increases can take place without an increase in the pace of monetary pumping.

By the same token, a strengthening in gasoline price rises cannot by itself set in motion a stronger rate of increase in general prices. Without the strengthening in the rate of growth of money supply relative to the rate of growth of goods there can?t be a general strengthening in price rises.

However, one could argue that a rise in inflationary expectations will cause the lowering of the demand for money, which with all other things being equal, will result in the decline in money?s purchasing power, i.e., a general rise in prices. However, what does a change in the demand for money have to do with inflation?

Inflation as we have seen is an increase in the money supply that leads to economic impoverishment through the increase in nonproductive consumption. There is however, nothing wrong with changes in the demand for money. This is no different from changes in the demand for any good. The fact that people want to hold less money doesn?t give rise to nonproductive consumption that sets in motion a process of economic impoverishment.

Likewise inflation is not about increases in money supply in excess of the demand for money. According to this way of thinking, as long as the increase in money supply is fully backed up by the demand for money there is no inflation. Note also, that in this way of thinking inflation is regarded as a general rise in prices. However, irrespective of the demand for money, once the money supply increases it sets in motion a process of impoverishment, which also sets in motion the dreadful boom-bust cycle.

It follows that the popular view, which asserts that by means of transparency the Fed can prevent rises in inflation, doesn?t hold water. Irrespective of how transparent the Fed is, what matters here is the rate of increase in the money supply. It is rises in the money supply that cause the physical damage to the process of real wealth formation irrespective of the Fed?s transparency.

Imagine that somehow the Fed did manage to convince people that central bank policies are aimed at stopping inflation and maintaining price stability, yet at the same time the central bank also raises the rate of growth of money supply. So even if inflationary expectations were stable the destructive process will be set regardless of these expectations on account of the increase in the rate of growth of money.

Note that people?s expectations and perceptions cannot offset this destructive process. It is not possible to alter the facts of reality by means of expectations. The damage that was done cannot be undone by means of expectations and perceptions.

Is the Fed an inflation fighter?
Between January 2001 and June 2004, the Fed had pursued an aggressive lowering of the federal funds rate target. The target was lowered from 6.5% to 1% by June 2003. To attain a given federal funds rate target, the Fed must constantly manage the flow of money to financial markets. Changes in the Federal Reserve?s balance sheet, also known as Federal Credit, depict the variability in the monetary pumping to sustain a given federal funds rate target.

Thus, to support a lower fed-funds rate target the yearly rate of growth of Fed Credit jumped from 0.7% in January 2001 to 12% by September 2001. Furthermore, during most of the 2003 period the rate of pumping by the Fed stood in excess of 9%.

The effect of Fed?s pumping is manifested by the up-trend in the growth momentum of the CPI since June 2002 (see chart). Note that the general rise in prices as depicted by the rate of growth in the CPI is driven by the past actions of the Fed.

By responding to the symptoms of inflation that the Fed has itself created the US central bank gives the impression that it fights inflation. Once it is realized that inflation is increases in the money supply, it becomes obvious that the source of inflation is the Fed and fractional reserve banking. It also becomes obvious that rather than fighting inflation, it is the Fed itself that generates the inflationary process. On this Mises wrote,

“To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying “catch the thief.” The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.”

It is amazing that almost forty years ago the champion of present inflationary policies, Fed Chairman Alan Greenspan wrote the following,

“The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy?s books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.”

For the past several weeks, Fed officials have warned the public about the growing inflation threat. Officials blame the growing risk of inflation on the rising price of gasoline as a result of the rise in crude oil prices and hurricane Katrina. Despite all this Fed officials are resolute that it is their duty to protect the US?economy from the inflation menace.

According to officials, what is needed to counter the looming inflation threat is to prevent an acceleration in inflationary expectations. This, it is held, can be achieved by pursuing a transparent and credible policy to counter inflation. It is overlooked by most experts that the source of inflation has nothing to do with the high price of oil and high gasoline prices.

The main source of inflation is the Fed itself. Various measures that Fed officials are promising to employ in the fight against inflation rather than fixing the problem will make things much worse. These policies only generate a further misallocation of resources, which in turn undermines the process of wealth generation.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Send him MAIL ?and see his outstanding Articles Archive. Comment on this article on the?Mises Economics Blog.?
Posted in Patriotic Dissent & Redress, US Bankruptcy, Fiat Currency & the Fed.