Does the Fed Fight Inflation?
The Federal Open Market Committee, the executive arm of the US central bank, has voted to raise the federal funds rate and the discount rate by 0.5%, to 6.5% and 6% respectively. In its press release, the Federal Reserve said,
Increases in demand have remained in excess of even the rapid pace of productivity-driven gains in potential supply, exerting continued pressure on resources. The Committee is concerned that this disparity in the growth of demand and potential supply will continue, which could foster inflationary imbalances that would undermine the economy’s outstanding performance
It would seem that the action taken by the central bank is aimed at countering the possible increase in the rate of inflation. Indeed most experts are of the view that the Fed has been too soft on inflation for too long; by raising interest rates by 0.5%, it has displayed strong leadership and determination to eradicate the inflationary menace.
In response to the Fed’s tighter stance, stock prices rose on investor optimism that the US central bank action will keep consumer prices in check. So it would appear that general rise in prices, labelled as inflation, is caused by an economic overheating i.e. demand exceeds supply. But how is it possible for economic activity to "overheat?"
In a market economy an individual exchanges by means of money goods that he produces for goods and services produced by other individuals. In short he exchanges goods that he produced for money and then exchanges money for goods and services he wants to have. Before an individual can exercise his demand for goods and services he must produce goods and services that can be exchanged for money. This in turn implies that production must precede consumption.
So long as every increase in consumption is supported by production, no overheating, so to speak, can occur. The overheating emerges once there is an attempt to raise consumption without the backup from production. "Overheating" requires the emergence of an exchange where individuals exchange nothing for money and then exchange money for goods and services.
This can only occur when the money supply is expanding. The increase in the money stock means that the newly printed money wasn’t earned; it originated out of the "blue." Once demand for goods and services, which is not supported by production arises, overheating will occur, which will take the form of a general rise in prices, labelled as inflation.
Since growing money stock is the ultimate source of overheating why is the Fed regarded as an inflation fighter? It is the central bank together with the fractional reserve banking system that makes the increase in the stock of money possible?
The reason why the Fed can masquerade as an inflation fighter stems from a misleading definition of what inflation really is. According to Mises,
What many people today call inflation or deflation is no longer the great increase or decline in the supply of money, but its inexorable consequences, the general tendency toward a rise or fall in commodity prices and wage rates.
In short according to Mises inflation is not general rise in prices, it is simply an increase in the money stock.
Why is this important? Once inflation is defined as a general rise in prices, then anything, which contributes to price rises, is called inflationary and therefore must be guarded against. Not only has the central bank in this framework nothing to do with inflation, but on the contrary the bank is regarded as an inflation fighter. A fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and therefore must be restrained by the central bank’s policies. Some other triggers like rises in commodity prices or workers wages are also regarded as potential threats and therefore must be always under the watchful eye of the central bank.
This way of thinking views the economy as an unstable entity, which is prone to self-inflicting damages and therefore must be under the constant supervision of the central bank. Accordingly, individuals are depicted as automatons that are driven by mysterious destabilising psychological factors.
However, regardless of psychological factors individuals actions are always conscious and purposeful. This in turn means that by striving to attain ends or goals individuals activities cannot be destabilizing but quite the opposite.
What disrupts this process is the existence of the central bank and the fractional reserve banking system, which permits the expansion of the money stock. It is the expansion of the money stock that gives rise to consumption that is not backed up by production and hence to economic overheating. In other words it is not overheating that causes inflation, but rather it is inflation that causes overheating.
The severity of this disruption i.e. inflation, is depicted by the loose monetary stance of the Fed. In January 1980 the US Federal Reserve Board’s money base stood at $132 billion. By the end of April the base was $573.4 billion, an increase of 334%. We can thus conclude that rather being seen as an inflation fighter, the FED should be regarded as the sole source of inflation.
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See also Greenspan Has Already Lost the Inflation Fight by Albert Freidberg.