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March 8, 2010

Courage Required to Curb Inflation

The most recent inflation report was frightening. The annualized estimate of inflation was in excess of 15 percent. Within the hour mortgage rates jumped 20 percent and the Federal Reserve increased rates on bank lending. Scary stuff this.

The good news is that the core rate of inflation (excluding fuel and food prices) was just under 5 percent annually. So, despite the immediate scare, there is some time, six to nine months perhaps, before the Federal Reserve will have to start raising interest rates to ward off inflation. The danger is that this will come before significant job creation, and so prolong unemployment. But many ask why should we be worried about inflation? 

Inflation is often thought of as a rich man’s problem. In the short run it is. Inflation reduces the value of savings, transferring wealth from the lender to the borrower. So, if you have a big house or car payment, and no savings, inflation may be a welcomed thing. If you have no debt, and much savings, inflation is simply a penalty on your thrift. But in the long run, inflation causes lenders to raise interest rates. Businesses slow borrowing, produce less and require fewer workers. Within a year or so, inflation becomes everyone’s problem.  

Over a year, five percent inflation is a bit worrisome, seven or eight percent a borderline national emergency, fifteen percent endangers the Republic. Happily, we will not have a year of even seven percent inflation. The Federal Reserve will not allow it, as it is obliged by law to maintain price stability. An increase in interest rates will prevent any such risk. Sadly, any such increase in interest rates will cause unemployment to remain high, or perhaps grow. The terrible recession of 1981-2 came about this way.  

So, the conundrum is how do we prevent inflation?  

Let me clarify, inflation is everywhere and is always a result of too much money chasing too few goods. The growth in the supply of money in the past 18 months dwarfs all other such episodes in the US (even when adjusted for inflation). We also have the largest (in inflation adjusted dollars) growth in the US deficit outside of the Civil War or World War II. And though it puts me in a minority, I agree with Paul Krugman, that the size of the debt is not as yet a problem. The rate of its growth is.  

Ignoring the stimulus and bank bailout, the Federal deficit has grown by double digits over two years. This sends a strong signal that the deficit will be a permanent policy. Spending must be deeply cut, especially in areas where the Stimulus remains unspent. Taxes may need to rise. Both acts will kill jobs, but prevent inflation. This will demand courage in the House and Senate – a commodity that is not oversupplied. Failure to do these things will have unhappy results: inflation and a slowing economy. In the end inflation is simply a tax on the cowardice of Congress.

Link to this commentary: https://commentaries.cberdata.org/21/courage-required-to-curb-inflation

Tags: finance


About the Author

Michael Hicks cberdirector@bsu.edu

Michael J. Hicks, PhD, is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. Note: The views expressed here are solely those of the author, and do not represent those of funders, associations, any entity of Ball State University, or its governing body.

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