What causes inflation and why do central banks allow it to persist instead of having a 0% inflation target.
In this episode you’ll learn:
- How inflation erodes purchasing power over time.
- How money creation by banks causes inflation.
- What is the non accelerating inflation rate of unemployment.
- How shorter-term rates influence longer-term rates.
- Why central banks have inflation targets.
Why Inflation Persists
A listener to my podcast recently asked, “Why does the Federal Reserve have a 2% inflation target? Why is inflation good at all?”
Inflation measures how prices of goods and services rise over time. As inflation increases, the purchasing power of the dollar or other currency is reduced. A dollar buys less today than it did 50 years ago.
A dollar worth of goods or services in 1967 would cost $7.33 today. Or put another way, a dollar today in terms of its purchasing power is equivalent to 14 cents in 1967.
Even a period of low inflation reduces purchasing power over time. Something bought in 2007 for one dollar would cost $1.18 today due to inflation, which means a dollar today in terms of its purchasing power is equivalent to 85 cents in 2007.
What Causes Inflation
Inflation occurs because the amount of money in the economy increases at a faster rate than the amount of goods and services available to purchase. If the amount of new dollars available to buy goods and services is greater than the amount of new goods and services produced, then that will push up prices.
The primary activity that leads to the creation of new money is commercial bank lending. Through the magic of accounting, whenever a bank makes a new loan, it creates a new digital bank deposit, which the borrower can then spend.
The more banks lend, the more money is created and the greater the risk inflation will accelerate.
Central banks, such as the Federal Reserve, are responsible for making sure banks don’t lend too much. Central banks pay close attention to the capacity of the private sector to produce goods and services. If capacity appears constrained, yet banks are accelerating their money creation by lending, then inflation can rise faster than the central bank’s target rate, which is a 2% annual inflation rate in the case of the Federal Reserve.
A key measure of the private sector’s ability to produce goods and services is employment. As the unemployment rate declines, it becomes more difficult for employers to fill jobs needed to expand the production of goods and services.
In a tight labor market, businesses compete for new workers and try to keep existing employees happy by increasing wages. As wages increase, businesses will often raise the prices of their products and services in order to keep existing profitability levels, and rising prices as we have seen is what inflation is.
What Is NAIRU?
Economists and central bankers believe there is a level of unemployment called the non-accelerating inflation rate of unemployment (“NAIRU”) below which wage pressures increase and inflation rises.
This is an unobservable unemployment rate, but Janet Yellen, Chair of the Federal Reserve, recently stated that she and the Federal Reserve Open Market Committee, which is responsible for making sure inflation stays close to their target, believe the normal longer-run rate of employment (i.e. another name for the NAIRU) is 4.6%. Currently the U.S. unemployment rate is 4.3%.
What is unknown is if the national unemployment rate falls below the NAIRU level, will inflation increase gradually above the 2% target or will it spike higher. In other words, is the relationship between unemployment and inflation linear or non-linear.
How Central Banks Control Inflation
The primary mechanism the Federal Reserve and other central banks use to control the amount of bank lending / money creation that leads to inflation is through adjusting interest rates.
The Federal Reserve sets a target for the federal funds rate, which is the interest rate that banks charge each other for overnight loans.
Although the Federal Reserve adjusts the target for this overnight interest rate, their actions and communications influence longer-term interest rates.
The Federal Reserve Bank of Philadelphia stated, “A lower federal funds rate reduces banks’ costs, which then leads other market interest rates, such as bank prime lending rates and mortgage rates, to fall as well, which lowers the cost of capital for firms and households and thus stimulates borrowing and hence the economy.”
In theory there is a level for the federal funds rate called the neutral federal funds rate that keeps inflation near the 2% target while maintaining full employment, a condition when anyone that wants a job can get a job.
In other words, the neutral federal funds rate is the rate at which unemployment is at or near the non-accelerating inflation rate and prices are generally stable.
When Janet Yellen was CEO of the Federal Reserve Bank of San Francisco, she used the story of “Goldilocks and the Three Bears” to illustrate the neutral federal funds rate, stating that “monetary policy should be at neutral only when economic conditions are ‘just right’.”
More often we do not have a “Goldilocks” economy. Either unemployment is too high or too low or inflation is too high or two low.
When the Federal Reserve believes unemployment is too high and /or inflation too low, it lowers the federal funds rate to encourage more bank lending and money creation, which can stimulate the economy and increase inflation and employment.
If unemployment appears to be below the non-accelerating inflation rate of unemployment and inflation and wage pressures are rising then the Fed raises its policy rate in order to discourage lending / money creation.
Why Isn’t The Inflation Target 0%
But that begs the question why is 2% the Federal Reserve’s inflation target? Wouldn’t a 0% inflation target be more appropriate so there is no inflation at all?
While there is no limit to how high the federal funds rate can be set to combat inflation, such as the 20% fed funds rate in in 1979 and 1980, there is a theoretical floor to how low nominal rates can go: Zero.
If nominal interest rates fall below zero that means you would pay your bank to hold your money. Financially, you would be better off withdrawing your money and stuffing it in a mattress. Massive deposit withdrawals would destabilize the banking system.
Of course, that’s the theory. As the Federal Reserve Bank of Philadelphia pointed out “In practice, economists and policymakers have recently been surprised to find that even market interest rates can go negative, likely because storing cash can be costly and risky.”
Still, the reason why the Federal Reserve doesn’t have an inflation target of zero is if it did there is insufficient room to stimulate the economy by lowering interest rates.
The Economist points out, “If inflation is low and real rates can’t fall far enough to boost demand and perk up prices, demand will weaken still further. This is the dreaded deflation trap.”
Deflation is a period of falling prices, which can be difficult to combat because households and businesses stop buying in anticipation of further price declines. This in turn, further slows the economy and increases unemployment, leading to a downward deflationary spiral.
Consequently, in order to avoid deflation, central banks set a target for inflation that gives them room to reduce interest rates when the economy is slowing and unemployment is rising.
In fact, some economists believe that the inflation target should be higher than 2% to give central banks even more flexibility.