Inflation - An Economist's Perspective (Transcript)

Mike Bryan, Economist
Vice President
Federal Reserve Bank of Atlanta

What is inflation?
Inflation is a decline in the purchasing power of your money. And you see it by an increase in the prices of the goods and services you buy. The cause of inflation is an increase in the quantity of money relative to the stuff there is to buy with that money. Money is like anything else; if you have too much of it relative to its demand, its value is going to fall over time.

What causes inflation?
Inflation always comes from whoever is in control of the money process. And in most places around the world, that would be the central bank. In the United States it's the Federal Reserve that ultimately has authority over all inflation. Inflation doesn't come from any particular good, so it's commonly said that high oil prices cause inflation. This is a fallacy. It's certainly true that oil is a very important product, but the argument goes something like the following: So when there's an oil shortage, oil prices go up and if oil prices go up that feeds through to just about everything else in the world, which means that their prices go up. Why that's a fallacy is that ultimately people have to adjust their spending habits; there just isn't enough money to go around. So if oil prices are going up and people are spending more money on oil, then they must be spending less money somewhere else or otherwise the economy is going to slow down. This can't be persistent. There are all sorts of things that can cause prices or so called "cost of living" to go up or down, and the central bank has no control over those. Some things are unfortunate, but they make your life a little harder to live. Inflation is something very different. Inflation is in all goods and services; they don't come from any particular good, it comes from too much money chasing too few goods.

The danger of hyperinflation
Inflation always gets bad for any economy where they just overproduce the amount of currency in circulation. In the case of the German hyperinflation, initially it wasn't so clear to the government, I don't believe, that the rising price level was a function of response to their excess of money creation. In fact, it's somewhat common to see stories where the government was complaining that the prices of things were rising, and that necessitated them to print more money so that people had enough money to buy the goods and services at these higher prices. They had a tendency to look at the high prices as being caused by other things, real things, when in fact the higher prices were caused by their policies of just printing too much money relative to the stuff there was to buy—and ultimately, it got out of control.

It's not just foreign economies that suffer with high rates of inflation. During the American Revolution, to fund the struggle for independence, the government created a lot of debt. And with that debt came over-creation of money, and the currency in circulation at the time called the "continental currency" was inflated away to almost worthlessness. So George Washington and others complained about the fact that they continued to see rising prices and the value of these pieces of paper that were being issued by the Continental Congress were virtually worthless.

Why do we need an independent central bank?
Today, governments recognize the temptation of using the monetary printing press as a mechanism for paying for fiscal imbalances. Central banks that control the money supply are often separated from their treasuries; they're made somewhat independent of their treasuries to make a clear distinction between the government that needs to borrow money to pay for the things that it needs and the people in control of the circulating medium: money. Indeed that's exactly why Congress separated the Federal Reserve System from the U.S. Treasury, and there are many clear distinctions between these institutions even though people oftentimes will confuse the Federal Reserve with the United States Treasury. The distinctions are there so that the monetary authority does not feel pressure from Congress or the political authority to solve fiscal problems with printing more money.

The Fed's dual mandate
Congress has given the Federal Reserve a dual mandate. One of the arms of the dual mandate is to maintain maximum employment. And the second arm of the dual mandate is to maintain price stability. And what price stability means is they don't want people to have to worry about what the purchasing power of money will be as they look over long horizons.

If you stop thinking about inflation as something that's caused by not enough oil or not enough food or any other number of real things that can affect how expensive it is for you to live somewhere, then we make clear the distinction between what the central bank can control and what it can't control. I think there's a common misperception by people that inflation makes it more difficult to buy things, and that's simply not true. Inflation means that anything denominated in dollars is going up. That also means your income is rising. So as the cost of goods and services are rising because of inflation, so too is your income. That's not the problem with inflation. Likewise, when we talk about deflation, it's the same sort of thing. Deflation is a generalized persistent decline in the prices of all things. So some people will say deflation is good because it makes it easier to buy things. That's not true. Deflation means everything is falling in value including your income. So it's not easier to buy something just because its price is less. You're also going to have less income to use to buy those things. One of the additional problems with deflation is that everything will fall in value except your debts. So as your income falls, and your debts stay the same, you're going to find that during the period of deflation it's increasingly difficult to pay back your debts. Sometimes it becomes so difficult to pay back your debts that you default. And when people start defaulting on their debts in large numbers, that puts enormous pressure on the banking system and you can have a great deal of problems that come from a deflationary environment. This is one of the reasons why I think the central bank is especially on guard right now for preventing the occurrence of deflation from taking hold in the U.S.

How is inflation measured?
Central banks monitor inflation using a variety of statistics. We look at commodity prices, we look at asset prices, we look at producer prices of all sorts, and especially we look at retail prices: the prices of the goods and services that most households buy. We also pay attention to inflation statistics called Core Inflation Statistics, which in the United States means that you strip away food and energy from the price statistic. This is a source of great criticism. People say well, of course I buy food and of course I buy energy, why would you take them out of the price statistic? And the reason you take them out of the price statistic is because these are real things that can fluctuate from month to month in a way that makes it difficult to see the underlying inflation.

The chain reaction
How inflation works its way through the economy—the transmission mechanism of inflation—is not very well understood by economists. But one thing that most economists tend to agree on is that the process is drawn out over a long period of time. What that means is that when the inflation starts, when the excess of money creation initially begins, and when it ultimately shows up in retail prices, it can be a relatively long period of time. So consequently, the decisions that central banks may make today might not affect the underlying rate of inflation for some time from today, maybe a couple of years from today. So when I think about that sort of thing, monetary authority might hit the first ball, but it could take some time before that last ball pops out as a retail price inflation. We look at all sorts of things that might give us a leading indicator of when the inflation process is starting to heat up. So for example, we might look at commodity prices like gold or platinum or anything else that an investor might try to grab onto if they start worrying that inflation is in the pipeline. You might look at expectations of workers or investors about what prices are going to do. You might look at all sorts of things that the prices of things are in short supply. Like for example, fine art, thoroughbred horses, luxury lots, yachts, anything that people might grab that will hold its value when the inflation ultimately hits. That might give you a signal that inflation has entered into the pipeline and ultimately will start showing up in retail prices.