Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. In fact, in the United States, the inflation rate has remained below 3.5 % each year since 2008. In Europe, price levels have also been depressed, with parts of the Eurozone experiencing what amounts to negative inflation — deflation. Inflation is generally measured using the consumer price index (CPI), which measures changes in the prices of a basket of goods over time or via the GDP price deflator, which looks at changes in nominal vs. real GDP growth over some period. (For more, see also: Why is Deflation Bad for an Economy?)
The European Central Bank, as well as the Peoples Bank of China and the Bank of Japan, are trying to battle deflation with expansionary monetary policies and via non-traditional policies such as quantitative easing to spark aggregate demand and encourage price levels to increase. Meanwhile, U.S. Federal Reserve chairwoman Janet Yellen has indicated that here, at least, an interest rate increase could be on the horizon. Why is there a disconnect between central bank policy in the United States compared with other influential parts of the world? Is the United States on the verge of a period of inflation? (For related reading, see also: Quantitative Easing: Does It Work?)
A Brief Overview of Inflation
The phenomenon of inflation has been a part of human society for millennia. Records spanning centuries for the cost of a military uniform in ancient Rome show a steady increase over time. Europe experienced periods of rapid inflation after major gold or silver discoveries or following long and destructive wars. With the breakdown of the gold standard in the 1970s, where national currencies were no longer pegged to the intrinsic value of gold but were instead free to float against each other in an open foreign exchange market, inflation became an even greater worry.
Gold, being rare and with only a small amount produced each year, is naturally deflationary. In other words, if the demand for gold increases with economic growth, but the amount of gold can only increase by a small amount, the value of an ounce of gold will naturally increase. If an apple costs one gram of gold and that gold became more valuable, it could now buy two apples. The cost of an apple has decreased from one gram of gold to one half of a gram.
Money not backed by gold, sometimes referred to as fiat money, is instead backed by the government issuing that money and their ability to levy taxes and control the money supply by adding or removing quantities from circulation. If people lose faith in that government, or if too much money floods the market all at once, that money could become less valuable. If an apple costs $1 and the dollar loses half of its value for whatever reason, it would now require $2 to buy the same apple. In other words, the prices have increased. Inflation caused in this manner is sometimes referred to as “cost-push” inflation. As the monetarist school economist Milton Friedman once remarked: “inflation is always and everywhere a monetary phenomenon.” If the government creates too much supply of money relative to its demand, prices will rise as the money loses its value in the marketplace. (For more, see: How the Federal Reserve Manages Money Supply.)
Inflation can also occur via a so-called “wage-pull” or “demand-pull” mechanism. In this scenario, economic output and growth is occurring quite rapidly, creating a great demand for labor to fill new job openings to continue the expansion. As a result of this demand, wages and salaries are bid up so that workers now have more money in their pockets. As that extra money is spent on goods and services, or invested in assets, the prices of those things will also become bid up until a new, higher equilibrium price level is achieved.
The Winners and Losers of Inflation
Regardless of the underlying cause of an inflation, a general increase in prices will always benefit some at the expense of others. Debtors, or those who owe money due to loans or obligations, generally come out ahead. If you have an outstanding loan with a fixed interest rate, such as a traditional mortgage, you will be obligated to make fixed payments on a regular basis until the debt is paid off. If you owe $1,000 a month on a $250,000 loan, you will be much better off if the value (or more correctly, the purchasing power) of that $1,000 is reduced. If the dollar were to lose half of its value, each loan payment would only “cost” you the equivalent of $500 going forward.
Corporations who have issued fixed-rate debt will likewise see the benefits. Sometimes people say that national governments with large amounts of debt to service will seek to “inflate their way out” of those obligations via the same mechanics. (For related reading, see: What You Should Know About Inflation.)
On the other hand creditors, or people who have lent money at a fixed interest rate, will feel the opposite effect. Each interest payment they receive will have effectively less buying power as price levels for everything else goes up. The financial sector, and especially banks, are usually most hurt in such situations as they are in the business of extending credit and making loans. Bondholders of corporate or government debt will also see the value of their investments decrease.
Is the United States on the Verge of Renewed Inflation?
A moderate amount of inflation (typically between 2% – 4%) is generally accepted by economists to be healthy for stable economic growth. Anything substantially more than that and the economy can “overheat” causing central banks to tighten monetary policy to prevent dangerous, runaway hyperinflation. At the same time, an inflation rate which is too low can lead to economic stagnation and an equally dangerous deflationary spiral which is difficult to recover from.
Since the Great Recession of 2008, the Federal Reserve, or the Fed, has reacted to low inflation by adopting loose monetary policy: lowering the target interest rate to close to 0%, and pumping money into the economy via open market operations by buying government securities in exchange for newly created dollars. Still, the U.S. economy did not experience growth enough to get inflation back up to where it should be and the Fed resorted to various iterations of quantitative easing (QE).
In quantitative easing, the central bank begins to prop up the prices of various asset markets by making purchases of non-government securities such as mortgages, corporate debt and even equity shares of publicly traded stocks. The overall effect of these measures is to make saving less attractive, and spending and investment more attractive. Since consumption and investment are the largest drivers of domestic economic growth, these actions make logical sense. (For more, see also: How Unconventional Monetary Policy Works.)
The problem has been that despite all of these efforts to inject money into the economy and make the cost of borrowing low, inflation and economic growth remained muted until recently. Now, headline unemployment has fallen to around 5% and the GDP has grown steadily. Asset markets such as the stock market have enjoyed steady growth from its post-recession lows and now the Fed has indicated that they will soon start raising interest rates.
The looming question is why has inflation remained so low for so long despite the country being awash with money. The answer could be that while central bank interventions increased the monetary base, or M0 money supply, those dollars were held in reserve by the banking system. In fact, the more important M2 money supply, which accounts for fractional reserve banking and credit did not see a marked increase during this same period. (For more, see: Why Didn't Quantitative Easing Lead to Hyperinflation?)
The Bottom Line
Even as Europe and other parts of the world are dealing with economic stagnation and deflation, the U.S. Federal Reserve has signaled that it soon will raise interest rates. After years of loose monetary policy and quantitative easing, this move may indicate that general price levels are finally going to rise and that the U.S. will begin to experience meaningful levels of inflation for the first time in nearly a decade. This expectation, however, could fall apart if the Chinese and European economies continue to run into trouble which ripples through global markets and destabilizes the economic growth the U.S. is currently experiencing. In fact, the Fed has said that it may hold off on an interest rate increase if market and economic data begin to slip prior to making their decision.