At his Jackson Hole speech, on August 28, 2026, the Fed Chairman Kevin Warsh recommitted the Federal Reserve to maintaining its 2 percent inflation target, calling it a “firm, fixed target.” At present, however, price inflation, as measured by the yearly growth rate of the Consumer Price Index (CPI), stood at 3.4 percent in July, down only slightly from 3.5 percent in June.
Against this background, the Fed Chairman hinted that, to counter the still-high rate of inflation, there may be a need to raise the Fed’s policy rate. He later did just that, raising the discount rate to four percent. But would a tighter interest-rate stance counter inflation?
The key issue here is the definition of inflation. Most economic experts, including central-bank policymakers, discuss inflation without properly defining what the term actually means. Yet, without a correct definition of inflation, it is not possible to determine its causes and, consequently, to formulate an appropriate policy for combating it.
Defining Inflation
To form a definition, it is helpful to go back as far as one could at the point in time when the subject of investigation emerged. Historically, inflation originated when a country’s ruler such as the king would force his citizens to give him all of their gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens.
On this Rothbard wrote,
More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the king and used to pay his expenses.
Because of the dilution of the gold coins, the ruler could now mint a greater number of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a gold alloy coin. The increase in the number of coins brought about by this debasement of gold coins is what inflation actually is. Given that in the modern world we do not employ gold coins as the medium of exchange, inflation is the artificial increase in the money supply.
Given that a price of a good is the amount of monetary units exchanged per good, it follows that the increase in money supply (i.e., inflation) will entail more money per good and, often, an increase in prices.
It also follows that the subject matter of inflation is misappropriation. On this Mises wrote,
To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business.
By popular thinking, inflation involves increases in the prices of goods and services as depicted by the consumer price index (CPI). In this way of thinking an increase in the demand for goods and services for a given supply causes increases in the prices of goods and services and thus in the CPI. Hence, on this logic, the lowering of the demand for a given supply will reduce the increases in the CPI.
Within this framework, an increase in the interest rate by the Fed will weaken demand and consequently weaken the rate of inflation as described by the CPI. The increase in the interest rate by the Fed, while it will weaken demand, will also set in motion the misallocation of resources thereby weakening the process of wealth generation.
An increase in the interest rate by the Fed in most cases does not correspond to the interest rates in a free market economy without the central bank.
High Interest Rate Policy versus Closing Monetary Loopholes
Let us contrast a tight interest rate policy to counter general increases in prices (wrongly labeled as inflation) with a policy that closes the loopholes of the money supply expansion. A policy of curbing money supply increases will undermine bubble activities (i.e., activities that emerged due to previous increases in money supply). The reason for this is because it will arrest the diversion of wealth from wealth-generators to bubble activities.
Such a policy would ultimately be great news for wealth-generators since now less wealth is taken from them. This, in turn, is likely to result in the expansion of the pool of wealth. This expansion, in turn, is likely to shorten the period of the economic slump and also make the slump less severe.
By employing an erroneous definition of inflation, Fed policymakers end up attacking the symptoms rather than the causes of inflation. As a result, they are making things much worse.
To counter inflation, what is required is to curb the increases in money supply and not increases in the prices of goods and services. By curbing increases in the money supply, the impoverishment of wealth-generators will be arrested too. This will revitalize the economy.
Again, given that the price of a good is the amount of money paid in exchange for it, it follows that a decline in money supply growth will also lessen the growth rate in the prices of goods and services and hence the CPI.
A major factor for the money supply increases is the expansion in the Fed’s balance sheet. What is required is to prohibit the Fed from buying assets. Note that the Fed is not a wealth-generating entity. Hence, when the Fed buys assets, it pays for it through inflated money and credit.
When money emerges via inflation no goods and services were produced for it. When the inflated money is exchanged for other goods and services we have a situation where no goods and services are exchanged for goods and services. That is nothing is exchanged for something due to inflation. This means that real wealth is diverted from the wealth-generators to the holders of the inflated money and credit.
Moreover, to prevent the emergence of inflation, the government should be prohibited from borrowing from the central bank to pay for its outlays. Also, the central bank should not be allowed to bail out banks that are engaged in lending that is not fully backed by production and private savings.
Conclusion
A tighter interest rate stance by the central bank inflicts damage not only to bubble activities but also to wealth-generating activities. This only prolongs the economic misery. If the central bank were to focus on the true inflation, which involves increases in the money supply, the effects of curbing the monetary growth rate will be the removal of the bubble activities and the strengthening of wealth-producers. Consequently, this is likely to shorten the period of the economic slump and also make it milder. It will also eventually soften the increases in the CPI. But none of this can be accomplished without a recognition of what inflation is and its consequences.
