What causes inflation?

Milton Freidman said, “Inflation is always and everywhere a monetary phenomenon.” This is still true.

There are two causes of inflation: Temporary and Permanent.

Temporary inflation is caused by price increases during disruptions such as storms, droughts, war, accidents, and other surprises. It ends with a period of deflation that reduces prices back to near their starting point.

Permanent inflation is caused by the Federal Reserve [The FED]. The congress has given the FED full authority to control the money supply. Control was necessary after the U.S. abandoned the gold standard. Without limits several countries, even major ones like France and Germany, printed excessive amounts of paper money to the point where their money was worthless. The FED and most other countries decided that inflation should be to two percent.

These days printing occurs with ink and paper but also with FED computer wires.

How does the FED fight inflation?

The FED has two techniques for fighting inflation and deflation. The most reported is their control of interest rates. The FED gathers data, and the Fed board of directors announces a rate that they think is appropriate based on the data they reviewed.

The FED also impacts interest rates by buying, selling, and not replacing bonds that mature; essentially burning the proceeds.

Right now, the FED has been primarily using the last technique, allowing bonds to mature, and taking the proceeds out of circulation at a rate of approximately one hundred million dollars a month. This is the reverse of the FED action when they bought bonds with new money to support the economy during the pandemic.

Why two percent?

When countries were on the gold standard there were centuries without inflation. This occurred despite the mining of gold adding two percent a year to the gold supply.

Not printing additional money was off the table as a consensus developed our growing economy needed additional money.

The two percent gold number was decided independently by individual countries.

Another advantage to growing the money supply by printing money was that the government received another source of funding, basically an invisible tax.

Most important to the FED was and still is a system that will never have deflation as we had in the nineteen thirties. The theory is that when prices are falling customers will accelerate the decline by waiting for even lower prices. Two percent inflation provides a two percent cushion before deflation begins and gives the FED time to act.

Why measure inflation rather than money supply?

It is easy and getting even easier. Think of Artificial intelligence checking all prices on the internet.

The money supply is not just the paper money in circulation. Banks create money. You deposited a Thousand dollars. I borrowed it. I put it in my account. The money supply just went up one thousand dollars. Measuring inflation is measuring the outcome of printing money, probably a better approach than measuring the amount of money in the system.

So, does the government get a two percent tax on the economy?

No. It is probably closer to four percent.

The capitalist system is designed to have two major advantages: innovation and price reduction. An easy example to see is computers. Every year they are better and less expensive. Even in the oldest industry in the world, retailing. A few years ago, economists calculated that Walmart reducing prices provided a greater benefit to the poor than all the government’s assistance programs.

Our free market competitive economy would probably reduce prices by two percent a year. So, if prices declined by two percent instead of two percent inflation, it would really cost us four percent a year.

Or maybe more. Inflation also raises most taxpayers’ earnings pushing individuals into higher tax brackets for income, capital gains and estate taxes.

The government also borrows money and pays interest. When the debt is low the printing provides a benefit for the government. When the debt is high, printing costs the government more in interest than printing provides. And you know who pays that cost. Interest is going to be the highest single cost item in the budget. Printing money provides only ten percent of the cost of interest.

We are not making a political statement about where or how much the government should spend or borrow. We just think that the efficiency of the economy is better when the value of an inch or a pound or a dollar does not change every year.

*in the case of a discrepancy between Fidelity Investments monthly statements and Katz Family Financial monthly portfolio statements, Fidelity Investment statements should be deemed as the correct and accurate report source.