Inflation is a problem that we have most fortunately not had to deal with for over forty years. The last great inflation took place in the 1970’s and reached double digits before being reined in by the Federal Reserve and the Treasury. The influence of Nobel Prize winning economist Milton Friedman was prominent during the era, and arguably led to the ultra-high, double digit, interest rates that helped to bring inflation under control. But what about the cost-cutting fiscal policies of the Reagan Administration that came to power in 1980. What role might they have played in corralling inflation?
Inflation Defined: Inflation is defined as an increase in the aggregate level of prices in an economy. We can see the price of gasoline (for example) rising, but what we are not noticing is that the value of the currency is decreasing. Gasoline recently (in California) was roughly $5 per gallon, but I can remember when a gallon cost less than half a dollar. It’s approximately the same gasoline (California has additives that other states do not owing to air pollution). But the value of the currency is not the same.
Monetary Policy: Monetary Policy comes out of Macroeconomics which is the study of economics with regard to whole economies, general levels of output and income, and the interrelations among the various sectors of the economy. More specifically, monetary policy means actions taken by central banks that apply to the currency, money supply, and interest rates. Dr. Friedman said that inflation is “always and everywhere a monetary phenomenon.”
Fiscal Policy: Fiscal Policy refers to the financial practices of governments—mainly in budgetary control, taxation, borrowing, and one we’ve gotten to know more about lately, stimulus. Huge stimuluses creating large deficits in the face of ultra-low interest rates have the tendency to pump up consumer demand. Supercharged demand can lead to inflation.
The Application of Fiscal Stimulus: Inflation occurs when the demand for goods and services outstrips the supply. The consequence is simple—the price goes up. When the supply of gasoline decreases and at the same time people start driving their cars more, the price of fuel goes up. If a house building boom is underway and the demand for electricians is greater than the available supply, the wages for electricians goes up. When a pandemic slows the economy down drastically, the demand for certain goods and services is restricted. Enter a large fiscal stimulus from the government and pressure on demand for these goods and services builds up as does savings and available personal credit. When the brakes on the economy are released, this demand pressure in the hands of consumers is also released as the consumers go about acquiring those same goods and services that were previously restricted. While the demand is blocked, producers are less likely to generate production that provides enough supply to satisfy the demand when it’s eventually released. To complicate matters in this day and age, the supply chain that brings us many of these goods is cramped with bottlenecks that were always there, but have shown to harbor unexpected consequences in time of crisis. The result of all of this is inflation.
Combatting Runaway Inflation: It has long been believed that Monetary Policy supersedes fiscal policy when it comes to battling inflation. For the last several decades the economy has gone through good times, rough times, and transitory times without triggering much in the way of inflation. Interest rates have risen and fallen, and another key ingredient has come into play in the form of increases to the money supply, or quantitative easing. Many economists expect that steady increases to the money supply would be ordinary and justified for a growing economy. But what we’ve seen since 2008 has been massive increases to the money supply from the Federal Reserve as they buy billions of dollars’ worth of treasury bonds releasing the cash into primarily the investment sector of the economy.
In the financial crisis of 2007/8 major amounts of stimulus were applied to the economy over the next decade including QE to keep it moving without inflation heating up. But what’s disconcerting is the huge amount of debt owing to fiscal deficits that also occurred. The QE process generally involves the Federal Reserve buying 10-year Treasury Bonds, or one arm of the government buying up the debt of the other. We can therefore view the national debt in a different light more as money in circulation than as a debt obligation, according to David Andolfatto of the Federal Reserve Bank of St. Louis. In ordinary times and with a strong element of moderation this process could continue without creating havoc. But as the debt ever increases and QE comes to the economic rescue, the danger of serious inflation increases dramatically.
Conclusions: Then all things considered is inflation a monetary phenomenon? I would say yes, but caution that both policies must work together instead of one element (Quantitative Easing) being counted on to protect the currency from the reckless fiscal deficits created by the government. If the government continues with massive deficits coupled with QE as an antidote, sooner or later the currency will suffer.
Sources: Free exchange | Of Milton and money, The Economist, December 18th, 2021.