by John Kernan

No one likes it when the price of something that they buy goes up (unless of course, it is in your investment portfolio). No one except, it seems, those ivory-tower dwellers at the Fed, who insist that prices should rise about 2% every year. How can inflation be good for the economy? Most economists agree that inflation serves several purposes.

First, it is in the interest of those who regulate our economy for people to buy and sell things- the more, the better (just don’t take out too much debt to do it). This is what we count to measure GDP (Gross Domestic Product) or how much “stuff” is bought and sold in a country in a year. When we see prices rising year after year, we tend to go out and buy what we want today to avoid the possibility of higher prices tomorrow. This gentle push speeds up our economy.

Second, having a bit of inflation keeps nominal interest rates up, even when real interest rates fall below zero. In English, that means that even if the economy is moving so sluggishly that the “natural” rate of interest is at or near 0%, inflation pressure will push it up a little, so the rate we actually see at our banks is something like 1 or 2%. That way, the central bank still has some wiggle room to fight the recession by lowering rates a bit further if necessary.

And third, inflation and unemployment are negatively correlated. As firms produce more, they need to hire more people, so unemployment declines. Since business is booming across the country, prices are also rising as the economy moves to (and beyond!) maximum stable output. This is the subtlest of the three points that we present here, and the Tufton economic team is resisting the urge to put in a technical graph to explain it. Suffice it to say that the monetary authorities won’t push back against a trend that means that more and more people are getting jobs.

Inflation means more jobs, which is great, but obviously we don’t want to end up with too much inflation, lest we become the next Weimar Germany and start papering our walls with cash. How does the Fed make sure that doesn’t happen? They raise interest rates.

The Federal Reserve doesn’t just go out their front door, post the new interest rate on a sign, and hope it goes well. Instead, they set the federal funds rate, which is the interest rate we’ve all heard of but don’t quite understand. It is simply the rate that banks charge each other for quick, usually overnight, uncollateralized loans of cash when they have a very short-term liquidity need. Banks use this rate to determine every other rate, and its influence spreads throughout the world.

Thus, when the federal funds rate rises, banks start charging more for a car loan or that new mortgage. Fewer people are willing to pay the new, higher rates to fund business expansion. At the same time, people see that they can now earn more money by just leaving their cash parked in a savings account, so they are less likely to spend it. Sitting in that bank account, the money can’t contribute to inflation.

The very existence of extra money doesn’t cause inflation. It is the money people spend that causes prices to rise. How many times per year a country’s cash changes hands is known as the velocity of money. If the velocity of money is low, and you have money simply sitting in the aforementioned bank accounts, then prices don’t rise – Fed’s goal at the start.

Other, faster-growing countries like India or Brazil often have inflation targets closer to 4% or 5%. It seems like a shame to lose 5% of your purchasing power every year. But then we remember the link between rising prices and rising production. People are getting more jobs, making more money, and expanding their businesses. The central bank wants to make sure they have a monetary environment to keep doing that.

We would be remiss not to mention that the level of inflation affects the stock market. If a company promises it can earn 8% more per share in three years, it means a lot less if inflation is sitting around 2%. An investor in equities might demand 2% a year for his time, 5% for the riskiness of stocks, and 2% to make up for inflation, for a total of 9% equity returns per year. If inflation expectations are flat, we would see 7% returns in the market per year – all else equal. Of course, all else is always equal in economics, but never in finance.

As this piece goes to press, the Commerce Department has just released its inflation estimate for February, indicating that prices had risen 0.2% from the month prior, and were up 1.8% from a year earlier. As we edge closer to that 2% target, we can expect the Fed to raise rates in order to prevent an economic overheating (inflation and other not-so-good things).

We hope that this discussion about the ins and outs of rising prices and monetary policy has enlightened you, or perhaps it has made your head spin. Hopefully, you now have an appreciation for both the complexity of our monetary system and the necessity for a bit of inflation.