What You Should Know About Inflation

In the early summer of 1957, Secretary of the Treasury Humphrey, testifying before a Congressional committee, gave a lucid lesson on the causes of inflation and an impressive answer to the advocates of cheap money.

The inflationists were contending at the time that the Administration had been reducing the volume of credit, and causing “inflation” and higher prices by raising interest rates.

As to the volume of credit, the Secretary had no difficulty in showing that it had actually “expanded substantially in the last four years.” “There is more credit outstanding today than ever before.” In fact, as the Secretary pointed out, if one counted mortgage, consumer, corporate, and other forms of nonbank credit, the total had increased over 1952 by the staggering sum of $146.5 billion ($135.8 billion from “savings” and $10.7 billion “from bank credit expansion, or increased money supply”). The “tight money” complaint, as the Secretary showed, merely reduced itself to this—that the government had put some limits on monetary expansion.

Humphrey gave the best official answer yet made to the frequent contention that an increase in interest rates raises prices because interest rates are a cost of production. On the basis of the gross sales of all manufacturers, he pointed out that of the cost of an article selling for $100, about 33 cents represented (explicit) interest. During the ten-year period since 1946 “prices of goods that consumers buy rose 27½ per cent, or $27.50 on a $100 item [due to labor and other costs], compared with the 20-cent increase due to higher interest.”

His comparisons in home-building were no less impressive. A house that cost $10,000 to build in 1946 would cost $19,000 in 1957. If the interest rate on an FHA mortgage increased from 4 per cent in 1946 to 5 per cent in 1957, then the monthly mortgage payment (on the basis of 15 per cent down and a twenty-year amortization) would increase from $51.51 on the 1946 house to $106.58 on the 1957 house. Only $8.71 of this increase would be due to the higher interest cost; the other $46.36 would be due to other costs raised by inflation.

But to hold down interest rates artificially is to encourage borrowing, and thereby to increase the money-and-credit supply. It is this increased money supply that raises prices (and costs) and constitutes the heart of inflation.

The real criticism to be made of the Federal Reserve in 1957 (and still) was not that it had kept credit too scarce and interest rates too high, but that it had yielded to inflationist pressure. It had made credit too plentiful and kept interest rates too low. It is precisely because interest rates were still too low in 1957 that the demand for credit still exceeded the supply. A discount rate of only 3 per cent (when 91-day Treasury bills yielded 3.404 per cent) was inflationary. The Fed might still be well-advised to follow the example of Canada and keep the discount rate always at least ¼ of I per cent above the bill rate. Such a course would not be sufficient to halt inflation, but it would be an indispensable condition. It would also have an important political advantage, for it would show that the Fed was merely following the market, and not arbitrarily raising interest rates.