Dealing with Inflation, Part 1: How the Fed will Protect You

Dealing with Inflation, Part 1: How the Fed will Protect You

Americans of middle age remember the corrosive inflation of the 1970s: Continually rising prices, particularly of gasoline, lagging wages with uneven attempts to catch up, high interest rates on borrowing but never high enough to compensate for inflation on savings, and — adding injury to insult — income tax liability on interest earnings that were only partial returns of inflation’s theft. No one — with the possible exception of a few oil well owners — wants to repeat that experience. In the 1970s, runaway inflation was the US dollar’s problem. It was solved in the traditional way, by raising interest rates enough to generate the severe recession of 1980-81. The lesson from that time is that the Fed has the tools needed to fight inflation — but unemployment and loss of income may be collateral damage. Is there another bout of inflation on the horizon? Will it be as long and painful as the decade of the 1970s?

Central banks (US Federal Reserve, European Central Bank, Bank of England) are in charge of maintaining price stability. They try to avoid inflation (general increase in prices and wages, eroding the value of currency and dollar-denominated assets) and deflation (generally declining prices and wages leading to economic stagnation). The US Federal Reserve (the Fed) has announced its target as a steady 2% annual inflation. But there is a difference in attitude: central banks hate excessive inflation; they hate and fear deflation. Why? Central banks know how to fight inflation: raise interest rates. They don’t really know how to fight deflation: they can’t reduce interest rates below zero.

Since 1982, US price inflation has been well contained (with occasional bursts of gasoline price increases and declines). Nevertheless, some Americans are concerned that the current low rate of inflation will be followed by a period of runaway inflation as a result of the flood of money that the Fed has placed in the banking system as part of its program of bond purchases (known colloquially as quantitative easing or QE3); see $tarrBuck July 17, 2013 for more on this topic. Fortunately, too much money doesn’t turn into inflation automatically —- first the excess money activates spending: excess demand for housing, consumption, and labor. Then prices and wages increase, apparently uncontrollably.

What can the Fed do if inflation does appear to start accelerating beyond its target? Is there any way to stop an apparently uncontrollable rise in prices? Generally, the Fed’s response to excessive inflation is to raise interest rates in the expectation that higher interest rates will slow economic activity and reduce price inflation. Higher interest rates also raise the return to holding dollar-denominated assets, reducing the pain of inflation.

  • Step 1 Reduce quantitative easing; stop or slow buying intermediate term debt
  • Step 2 Raise short term interest rates: discount rate, federal funds rate, yield on Federal Reserve Bank deposits (held by banks)
  • Step 3 Reverse quantitative easing: accept bond repayment on maturity; sell bonds back to market.

The Fed’s first step will be to reduce its quantitative easing. That means it will stop or slow its buying of intermediate term bonds (up to ten year maturities) and stop adding cash to the already abundant supply in the banking system. That move will increase interest rates on mortgages and most intermediate to long term debt. Increasing interest rates slows new housing construction and the purchase of capital equipment by businesses. That slowing of economic activity may be enough to slow the inflation.

But suppose inflation continues and perhaps accelerates, what can the Fed do next? The next move will probably be to increase short term interest rates. It will take three steps, probably at the same time. The Fed will raise its discount rate (the interest rate that it charges on lending directly to banks). It will increase the yield it pays to banks on deposits in the Federal Reserve system. Further, the Fed will act to try to raise the interest rate on interbank lending, the Federal Funds rate. The way it raises the Federal Funds rate is by selling Treasury bills (short term US government debt) into the Treasury debt market. That drives the price of bills down and the prevailing yield up.

And if inflation is still accelerating? The next step is to reverse quantitative easing. First by allowing the debt instruments acquired over the last several years to mature, debtors will repay cash to the Fed taking it out of circulation. Then the Fed can start selling its large holdings of intermediate term bonds back to the debt market, again withdrawing cash from private hands. Even before that selling takes place, market participants — fearing the flood of bonds coming back into the market — will bid down bond prices and bid up interest rates. When the sales take place, the increase in interest rates will be confirmed.

By that point in the tightening process, home builders and buyers may be crying for mercy. New housing construction and new business purchases of capital equipment will have slowed and their slowing will trigger a general contraction of economic activity. Meanwhile, prevailing interest rates will have caught up with inflation rates. That should be enough to slow and counter the inflation. Meanwhile, savers and other holders of cash assets will find that interest rates have increased enough so that they are no longer losing purchasing power as savers; their interest income overcomes the loss of purchasing power through inflation.

Bottom line: There’s not much to fear from the inflation that isn’t here yet. The Fed has ample tools to deal with inflation, to contain it and reverse it if need be. But they are not costless. Once the inflationary process starts and gets well integrated with the rest of economic activity, slowing the inflation may require an economic slowdown with increasing unemployment. The time to stop unwelcome inflation is before it starts, raising interest rates and tightening monetary policy when excessive inflation is expected but has not yet appeared.

Copyright 2013, Ross M. Starr


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