What causes inflation and why is it bad?

What is inflation? Well, most of us think of inflation as rising prices. And, indeed, prices do rise during an inflationary period, but the price of all goods and services do not usually rise at the same rate. Some prices may even fall while others rise at a much higher rate.

Rising prices are symptomatic of inflation, but not the cause. A weighted average of price changes is how we measure inflation. The Bureau of Labor Statistics calculates the inflation rate based on how much consumers are paying for a mix of food, energy, “commodities” (tangible goods) and services. This statistic is referred to as the Consumer Price Index (CPI). Sometimes you will hear about a figure called “core inflation.” They calculate that one by leaving food and energy out of the CPI on the grounds that food and energy prices are “too volatile” and would distort what’s really going on.

OK: but what causes inflation? Let’s look at the money side of the economy, not just the prices side. At any one point in time there is some finite amount of money in the economy. People think of money as currency; but in fact, checking accounts and certain other highly liquid financial assets and obligations are included in the definition of “money.” The Federal Reserve System (the “Fed”) is in charge of controlling the supply of money. (Incidentally, people think of the Fed as a huge organization that makes gigantic profits at the expense of “the people.” But in fact, every year the Fed gives its profits to the U.S. Treasury. The 2021 amount of that payment was $107.4 billion.)

The Fed can use purchases of Federal Debt and control of interest rates to expand or contract the supply of money. If they lower interest rates, people (and companies) tend borrow more. That expands the supply of money. If they raise rates, it chokes off some of the demand for money and the supply falls.

Now let’s see how the money supply expands as a result of the Fed buying new federal debt. It’s really simple. The Fed creates more money by writing a check on itself which it uses to buy new Treasury bonds. The government now has more money to spend and the Fed has more bonds. The money supply is larger.

Is a growing money supply good or bad? It depends. If the expansion of the money supply is matched by growth in the production of goods and services, there is a rise in our standard of living. If the money supply is growing faster than production, money-holders will bid prices up and there will be inflation.

The Fed walks a tightrope. Their mission is to allow the money supply to grow rapidly enough to support economic growth (as measured by Gross Domestic Product, or “GDP”). Economic growth, in turn, lowers unemployment. We want to have low unemployment (3 or 4%?). But if the money supply grows too rapidly, we have inflation. An inflation rate of about 2% is viewed as “acceptable.”

Does this mean that whenever the federal government is running a deficit, and therefore issuing more debt, the result will be inflation? Not necessarily: it depends on who is buying the bonds. Private investors, including companies, especially banks and insurance companies, often buy federal bonds. If this allows all the bonds to be sold, there is no effect on the money supply: money is just moved from private investors’ accounts to the Treasury’s.

But lately, the government has been running huge deficits and is therefore trying to sell huge amounts of new debt, and the private sector simply can’t buy it all. And while government debt is safe with respect to default risk, there is a growing amount of inflation risk. If the inflation rate is higher than the interest rate, investors will have less purchasing power at the end of the year than they started with. This is referred to as a “negative real rate of return.” And the government has been putting lots of pressure on the Fed to keep interest rates low (in the range of 1 or 2%). Soooo, the Fed is having to buy all the bonds and this means the money supply is growing rapidly and we have inflation.

How much inflation are we having? An organization known as USA Facts collects a large amount of government data and reports it (on the web) clearly and accurately. They report the following inflation information: from December 2020 to December 2021 the CPI increased by 7.04%. The average annual inflation rate over the 10-year period December 2010 to December 2020 was 1.74%. If the inflation rate during the next 10 years averages 1.74%, it will take $118.84 to buy what you can get for $100 today. If the average rate of inflation is 7.04%, after the next 10 years what you can buy today for $100 today will cost $197.45.

The Fed’s holdings of U.S. Treasury Securities in December 2010, was $1,007,837 million (one trillion dollars); in March 2020, they held $2,502,624 million (two and a half trillion dollars); December 2021, $5,652,272 million (almost $5.7 trillion). In other words, there was an increase of about $1.5 trillion over the 10-year 2010 to 2020 time period, or roughly $150 billion a year. But during the last 21 months the increase was $3.2 trillion (a rate of about $1.83 trillion a year. Meanwhile, what was happening to the economy?

During the 2010 to 2020 period, GDP grew from $15.0 trillion to $20.9 trillion, which translates to an average annual rate of just under 3.4%. Note that this growth rate is almost twice the 1.74% average inflation rate—good times. During 2021 we had inflation over 7%, but the most optimistic estimates of GDP growth are running about 5.5%. That number is likely to decline with second and third revisions (during February and March). In any event, inflation is outpacing GDP growth—not good.

The Fed has announced it will take measures to reduce inflation starting in March. This means they will raise interest rates and curb expansion of the money supply. This will require fiscal discipline at the Federal level. That will be hard to achieve.

Why is inflation undesirable? There are several reasons. First, it makes corporate profits appear larger than they really are. The accounting process is based on “historical cost.” Assets are depreciated using the original cost of machines and buildings. When there is inflation, the cost dollars are usually significantly less than the current replacement cost. Also, the cost of parts inventories is often less than the cost of replacing the inventory used, so the cost of parts is understated. Since investors rely on accounting statements, we have inefficiency in capital allocation. It also results in corporations paying higher income taxes than they should be paying.

Also, it is easier for companies to raise prices than it is for workers to raise their wages. Therefore, conflict and resentment abound.

The only real winner with inflation is a debtor who owes monetary amounts that do not adjust to inflation. Who is the world’s biggest debtor? Why, it’s the good old U.S. of A. How’s that for incentive?

How can individual companies and investors position themselves to benefit from inflation (or, at least, to minimize the pain)? Well, first you should reduce your holdings of fixed, monetary assets such as bonds or mortgages which will produce only the contractual dollar amount of income. If the inflation rate is high (the value of the dollar is falling), your real income (in terms of purchasing power) will drop — and if the inflation rate is higher than the rate of interest you earn, your real income will be negative. Rather, invest in “real” assets (land, gold, gems, buildings, etc.) whose value will rise with inflation. On the other side of your balance sheet, add monetary debt. This requires some confidence, but increase your mortgage or buy an expensive car on credit. The value of the asset should rise and the “real” burden of the debt should shrink.

Willis (Bill) Greer is a retired dean of the College of Business Administration at the University of Northern Iowa. He lives in Rollins.