-Caveat Lector-
~~for educational purposes only~~
[Title 17 U.S.C. section 107]
Does the Fed Fight Inflation?
by Frank Shostak
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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