The Fed claims to be committed to fight inflation by hiking interest rates and reducing their asset purchases. Interest rate will be set to 2% in a year from now. However, with prices going up by almost 10% a year, this is hardly going to impress anyone. People will still borrow to buy stuff. People with access to cheap credit can make money by borrowing at 2% to buy stuff that goes up in price by 10%.
The proper financial definition of the word inflation is an increase in the amount of currency in the economy. So there will be inflation as long as people keep borrowing currency. With the Fed itself doing this, and commercial banks still having plenty of customers willing to borrow, there will be inflation.
If the Fed was serious about fighting inflation it should halt its asset purchases and set interest rates at or above 10%. Only then would there be a halt in the expansion of currency.
The exact level at which the interest rate needs to be set is hard to say. There is a point where people will start returning their borrowed currency to banks, and thus create deflation. Every loan that's repaid results in currency leaving the economy. If there's a lot of this going on, prices of all things will start to drop due to a need to cover debt obligations.
It's impossible for a central bank to judge exactly where the threshold is between inflation and deflation, so the Fed is going to err on the side of inflation. It's stated target is a 2% increase in annual prices. The Fed calls this its inflation target. But it's not really about inflation. It's about prices. The Fed is deliberately muddling the distinction between inflation and price inflation.
Inflation is an increase in the currency. Price inflation is an increase in prices. Inflation is something the Fed influences directly with its interest rates and asset purchases. Price inflation is a secondary effect, sometimes delayed for years. To focus on price inflation is therefore disingenuous. It allows the Fed to make bad decisions on inflation, claiming that they are harmless due to the time delay between inflation and price inflation.
This is not due to ignorance at the Fed. They know exactly how inflation feeds into price inflation. They know that price inflation is due to a combination of inflation and the speed at which currency circulates in the economy. It's possible to delay price inflation by reducing people's expectations. If there's a war or a pandemic, people cut back on their spending. A coordinated campaign of fear allows the Fed to inflate without there being a corresponding increase in prices. However, once prices start ricing, the rate at which people spend goes up, and we get price inflation.
Out of control price inflation is called hyperinflation. It typically happens after a prolonged period of inflation. The only effective way to stop hyperinflation is to stop the creation of currency. Interest rates must be set high and asset purchases must stop. This will re-price everything according to the amount of currency in the circulation.
As things stand, prices are going to continue up. There's nothing more to be gained by the Fed in the time delay between inflation and price inflation. The opposite is the case. Prices will continue up on momentum no matter what the Fed does, save a massive liquidity drain. Only deflation will save the US from price inflation. The Fed must encourage people to return their borrowed money. But that would pop every investment bubble, and is therefore unlikely to happen any time soon.
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| Marriner S. Eccles Federal Reserve Board Building |
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