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Where Does Inflation Come From?

Brian Wesbury 9 July 2008 2 Comments

In his final warning before hiking interest rates last week, European Central Bank (ECB) president Jean Claude Trichet said, “If we are not resolute, there is a risk that inflation will explode.” With this he lifted the overnight lending rate to 4.25%.

We are not sure of the exact numerical definition of “exploding inflation,” but the ECB is clearly worried that 3.7% growth in the European CPI over the past year is fueled by more than just energy and food.

This leads us to ask a rhetorical question: where does inflation come from? Sometimes an answer can be found at the extreme and today’s extreme on the inflation front is Zimbabwe, where prices are doubling every month.

So why is this happening? Is it due to rising commodity prices? Or, rising wages? No. Zimbabwe is experiencing hyperinflation because the government is printing money to meet its payroll. They have printed so much money that it has become virtually worthless.

As Milton Friedman taught, inflation is everywhere and always a monetary phenomenon. The only way inflation can exist, let alone “explode,” is if a central bank or government prints more money than an economy needs. What determines the need for money is the increase in goods and services. If the money supply grows faster than the growth rate in goods and services, the value of money will decline.

Inflation is too much money chasing too few goods.

Imagine an economy with 10 apples and $10, each apple will cost $1. If the money supply is increased to $20, then the price of apples will increase to $2. If the apple supply increased to 20, and the money supply doubled to $20, then apples would still cost $1.

This is why rising oil and food prices by themselves are not inflation. As long as the money supply does not increase, any increase in spending on oil or food would be offset by a decline in demand for other goods. Other goods prices would be forced to fall; and the overall price level (inflation) would remain unchanged.

Milton Friedman won the Nobel Prize for explaining this mechanism. And despite the fact that many people want to relegate monetarism to the ash heap of intellectual history, it remains the only true and correct explanation of inflation.

What’s interesting is that the ECB understands this, and has institutionalized Friedman’s monetary thinking. By law, the ECB has a “single mandate” for monetary policy – price stability.

On the other hand, the Federal Reserve has a “dual mandate.” Congress says the Fed must promote “maximum employment” and “price stability.” This dual mandate is conflicting. In fact, the more the Fed focuses on employment and economic growth, the higher the probability that commodity prices and inflation will rise, the dollar will fall, and the economy will suffer.

In fact, if all we knew about the ECB and the Fed were that the former had a single mandate and the latter had a dual mandate, we could easily make a forecast for the direction of exchange rates. Think of it in terms of football. If one team had a single mandate from management to win, but the other team had a dual mandate to keep it uniforms clean and win, the first team would win a huge percentage of the time.

In other words, the longer it takes the Federal Reserve to hike rates and tighten monetary policy, the weaker the dollar will become and the higher inflation will climb. We do not believe inflation will “explode” in the US, but elevated readings in the 3% to 5% range are clearly on tap for the next few years.

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Brian Wesbury is the Chief Economist at First Trust Portfolios and a regular columnist with the Chicago Daily Observer.

2 Comments »

  • timjowers (author) said:

    Totally agree. Inflation is simply a way to steal from the savers. It worked OK for America for a few decades because they were stealing from the future generations and from the workers in China and other places. Today? The compounding problem means they cannot inflate enough to feed the debt monster. Its simple math: exponential growth cannot continue without a bust. In this case, the FED is trying to hyper-inflate (if you had dollars you lost 15% or so each year) in order to fund government excesses and make the bankers rich. But, overall, it was stealing from the middle class for the last two decades and now must expand to steal from the lower class too (aka commodity price inflation). It simply shows the FED does not work for the American people but for bankers and government over-spenders.

    The FED and US Government engineer inflation. Deflation is normal in a scientifically advancing and business improving society. Inflation is a tool to create poverty from work. It is a tool to steal what has been given (steal pay after payment has been made!)

  • jmrowland said:

    All this explanation, yet we still don’t understand inflation.

    Clearly, if a bank were to create more paper money today and give it to me, I would be able to spend it. I would know, and the bank would know that it was created out of whole cloth and, according to the theory of inflation, “worthless.”

    Yet, I would still be able to take this pile of money out of the bank and go down the street and exchange it, immediately, for goods and services. I could even invest it with another? the same? bank and use it to “earn” more money. I would continue to be able to do this for some time to come… and then, the orthodoxy goes, it will “catch up” to me, and at some point, I will have to spend more of this free money in order to obtain the same amount of goods or services.

    There’s clearly a time gap involved, and this gap is where we experience inflation. But what is the gap? How long before my new money goes bad and its worth begins to decline? And how fast does it decline? Is it a function of time, or is it a function of how many hands it passes through? …and if the latter, how many hands? …and whose?

    What is the “mechanism,” always hinted at but never stated, by which the total amount of goods and services is compared against the total amount of available cash and one of them is found to be too little or too much for the other? If you answer “the marketplace,” I must respectfully respond, “Untrue,” for, as I’ve already demonstrated, the marketplace is rather easily fooled. The marketplace will continue to cheerfully accept my worthless cash. Until somebody tells them it’s worthless. Somebody they will believe.

    More to the point, how many individuals and institutions are already taking advantage of this gap right now, are in the business of mining the gap, concentrating wealth for themselves at the expense of inflation for the economy as a whole?

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