A Recent History of Inflation

October 9, 2008 in Economics by DJ | 1 comment


(Chart by the author using data from this site; image from thinkpanama.)

“People know that inflation erodes the real value of the government’s debt and, therefore, that it is in the interest of the government to create some inflation.” –Current Fed Chairman Ben Bernanke (2002)

Ben Bernanke made this statment as one argument why deflation was unlikely: governments benefit from inflation, therefore inflation would normally be promoted. At the time, deflation seemed a real possibility: the Consumer Price Index (CPI) had risen only 1.6% over the 12 months of 2001. At the time, Ben Bernanke was not Fed Chair.  Both of those facts would soon change.

Ben Bernanke became Fed Chair in February 2006.  For the prior year, the CPI rose at 3.2%. In 2006, it rose only 2.9%– a very reasonable rate of inflation.   

Then something changed.  During the twelve months of 2007, the CPI rose 8.6 points, or 4.3%. From January to August of this year, it rose another 8 points, for an annual rate of 5.7%. That’s the highest rate of increase since 1989, when it jumped 6.2%. To find a year with an increase greater than that, you’d have to go back to 1979-80, when it rose over 10%.

What caused this sudden resurgence of inflation?  The Bush administration’s policy of excessive deficit spending surely promoted inflation, but why did it take such a sudden turn for the worse after six years of bad budgeting?  Because 2007 was when Bernanke began dropping the Fed Target Funds Rate (the “Prime Rate”): from a high of 4.25% in June 2006 to 4.25% in December 2007, to 2.0% in April 2008– and now to 1.5%.  The Prime Rate comes down, and inflation goes up.  That’s hardly a coincidence: the Prime Rate is considered the main tool a government has for controlling inflation.

For a moment, let’s ignore the housing market, the credit crisis, and the plunging stock market.  What happens when inflation rises and the Prime Rate remains low?  First, more inflation, since banks are pleased to borrow money at cheap rates with the idea of lending it to others (you and me) at higher rates.  As they borrow money from the treasury, more and more money goes into circulation.  That’s the very definition of inflation.

But something else happens, too: as one analyst noted back in May of this year when the Fed had dropped the Prime Rate once again,

“What kind of a bank would lend money for less than the inflation rate? Isn’t it sure to lose money?”

Sure, banks love to borrow cheap money. But they’re loathe to lend cheap money when it’s below the rate of inflation.  In order to make money, they need to lend their money at a higher rate.  That means the supply of cheap money lent between banks and from banks to businesses dries up.

Not surprisingly, AP this week described the current credit crisis in these terms:

“The lending lockup is a key reason why the U.S. economy is faltering. Unable to borrow money freely or forced to pay a high cost to borrow, employers are cutting jobs and reducing capital investments.”

Think about it: why would I loan you money at 1.75% when the inflation rate is 5.7%? I wouldn’t; that’s just basic basic common sense.  So what the Fed has effectively done by dropping interest rates and encouraging inflation is to limit short-term lending to only those institutions that don’t care if they make a profit: in other words, the Fed.

There’s an upside to all this for the federal government: As Bernanke noted in his 2002 comments, inflation makes it easier to pay off the (now staggering) national debt.  But there’s a downside, too: borrowed money gets more expensive, and companies (and even nations) that rely on cheap, short-term credit can’t get it.  That means lost jobs, lower profits, and less tax revenues– ultimately causing more national debt.  But of course that new debt is soon worth less because the currency is worth less.  The theory is to harness inflation so it works for you instead of against you.  But it only works in conjunction with ever-rising debt.  That should frighten us more than a little bit.

I don’t wish to imply that Benanke single-handedly created the current financial crisis; he didn’t.  There’s plenty of blame to go around.  GOP deregulation, Dem expansion of the housing market, GOP privatization of Fannie Mae, Bush deficit spending, and Greenspan greed-is-good policies all contributed to a complex crisis with many interlocking facets.  But Ben Bernanke, by following what appears to be a fringe economic theory, has taken a challenging situation and made it far, far worse than it needed to be.

Our economic system looks to the Federal Reserve to manage the money supply in such a way as to encourage the health of our overall economy.  Yet the current Fed Chair, by encouraging jnflation with irrationally low interest rates, has turned the housing bubble into a global crisis.  In short, I submit that the man driving this bus can’t see the road.