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Inflation became a prominent issue in 2021 and 2022. During the summer of 2022, when inflation reached 9% in the U.S., inflation was the number-one concern among households. It was gnawing at family budgets, so much so that some said they feared inflation more than any other economic woe – even a stock market crash or deep recession.
While the inflation scare has eased, the pervasive notion that government debt and spending cause inflation hasn’t, however, been dispelled. Indeed, this misperception about inflation illustrates nicely the underlying misunderstandings about government debt, which too often cause poor policy choices and skew our capacity to predict or understand economic crises.
Fears of inflation arise, in part, from the fact that its sources seem mysterious and uncontrollable while it extracts immediate, adverse effects on essentially all people’s lives and household budgets.
Consider these four basic points:
- Inflation has been infrequent in U.S. economic history. It has usually receded quickly once its underlying cause was addressed, without the need for high interest rates. For instance, in World War II, inflation peaked at 14.4% in 1947, but quickly dropped to -1% by 1949, even though interest rates were only just above 2%.
- Inflation is not a monetary phenomenon. In other words, it’s not a function, or artifact, of the Fed putting copious amounts of new money into the economy. For the 47 largest countries in the world where we have sufficient data, there have been only 30 instances where money supply doubled in five or fewer years. Of these, only seven were followed by inflation – meaning that more than three quarters of the time, high money-supply growth was not followed by high inflation. Further, high inflation has often not been preceded by high money-supply growth. A similar pattern holds for high government-debt growth.
- Although raising rates will indeed help to tame inflation, it does so only in the most blunt and painful way. With the highly favorable 0.17% increase in CPI in July, we have now had mild inflation for 13 consecutive months, and that favorable trend started when interest rates were only 2%, well below today’s crushing highs.
- The current wave of inflation is largely the combined product of the pandemic and the war in Ukraine, where Russia and Ukraine have long been key suppliers of some of the world’s most important commodities including oil, natural gas, and wheat. With the war, the price of these three key commodities shot up to astronomical highs, but those prices have abated.
These three commodities play an outsized role in determining inflation levels around the world. Analysts have estimated that about one-third of the U.S. inflation rate in summer 2022 was due to the Ukraine war. Yet there was an almost universal conviction that government spending, government debt, and profligate “printing” of money were the real culprits, on the logic that more money chasing the same quantity of goods would translate into that money buying less – the very definition of inflation. This meant that the primary solution being employed was to raise interest rates. Some were even convinced that the Fed had waited too long to raise rates and thus had missed its opportunity to control inflation.
Setting aside the inconvenient belief that the initial rate increase occurred less than one month after the Russian invasion, these critics argued that if the Fed had only moved more decisively and more aggressively, inflation could have been leashed, but now that it was on the loose, there was no way to contain it except with even higher interest rates.
This theory was widely espoused in the 1970s and has subsequently taken the form of dogma. But since then, we have had four decades of new experience and data, spread across a wide number of countries, and the data refutes the dogma. Resoundingly.
Inflation has improved not because of high interest rates, but instead as problems with supply chains have been remedied and as the world has overcome some of the adverse price impacts of the war. We still have the risk of future price flare-ups from the continued war in Ukraine, and Europe will struggle more than the U.S. with inflation since its ill-advised energy dependence on Russia has meant its price of natural gas, as one example, is five times higher than in the U.S.
Among economic calamities, including banking crises, stock market crashes, currency collapses, and other disasters, inflation has impacted the world the least on a GDP-weighted basis. But because its impact on households is so direct and painful, it’s highly consequential politically, which is why it will always command our attention.
Richard Vague is the author of numerous books. His new book is Paradox of Debt: A New Path to Prosperity Without Crisis (Univ of Pennsylvania Press, July 11, 2023). His career has spanned fields as varied as banking, energy, government, and the arts. He recently served as Secretary of Banking and Securities for the Commonwealth of Pennsylvania. Vague previously was managing partner of Gabriel Investments, an early-stage venture capital company; was also co-founder, Chairman and CEO of Energy Plus, an electricity and natural gas supply company; and also co-founder and CEO of two banks – First USA, which was sold to Bank One, and Juniper, which was sold to Barclays PLC. Learn more at richardvague.com.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
