Last week, the U.S. Federal Reserve decided to maintain short-term interest rates at 5.25 percent for its third consecutive meeting. Despite an apparently cooling U.S. economy, the Fed clearly remains concerned about inflationary pressures. What the Fed calls “core inflation” - which excludes goods with volatile prices such as energy – has risen since February from 2.1 percent to 2.9 percent. This is its highest level in a decade.
Though this exceeds the average Eurozone inflation rate (1.7 percent), inflation rates in emerging markets, including developing nations, are considerably greater. Argentina's annual inflation rate is currently 10.4 percent. Venezuela's hovers at 15.3 percent, Colombia's at 4.6 percent, and Mexico's at 4.1 percent.
Even so, these figures seem light years away from the hyperinflation that once crippled many developing nations, not to mention the stagflation that shackled Western economies in the 1970s. So why, some ask, should we – or the Fed – be concerned about these figures? Some believe that a little inflation has economic benefits. The prospect of the value of our savings being diminished by inflation, the argument goes, gives us incentives to invest our money more aggressively to seek returns that exceed expected inflation rates, thereby further stimulating the economy.
Whatever this argument's merits, they pale in comparison to the reasons why vigorous anti-inflationary monetary policies are not only economically sound, but also morally essential. To understand this, we need to comprehend inflation's nature.
Inflation is the depreciation of a currency's purchasing power. This once occurred through governments debasing their currencies – such as mixing bronze into gold coinage – to artificially reduce their debts or fund increased spending. When such policies were implemented by the sixteenth-century Spanish monarchy, they were condemned as fraud by Spanish theologians.
Today, this depreciation occurs via increases in the amount of fiat currency circulating in an economy relative to the economy's potential output. In the 1930s, Lord Keynes argued that if governments increased the money supply, this would stimulate demand and therefore employment. Keynes was thus delighted when the British government stopped pegging the pound to the gold standard in 1931, precisely because he knew the link had limited government's ability to pursue this type of demand-stimulation.
But as former Fed Chairman Alan Greenspan wrote in 1966, “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation."
A second moral and economic problem with inflation is that it thrusts more and more people into higher-income tax-brackets while simultaneously decreasing their money's spending power. Thanks to inflation, a family's income which fell into a middle-to-low income tax-bracket in 1980, for example, will almost certainly fall into a high-income tax-bracket in 2006. Inflation thus allows governments to avoid the requirement of natural justice concerning gaining the people's consent before levying or increasing taxes.
A third problem stemming from inflation is that it undermines economic liberty by impairing the ability of entrepreneurs, businesses, and consumers to make sound economic decisions. Inflation makes it harder for businesses to discern whether their cost-increases are real, or whether they are simply the effects of inflation. This also makes it more complicated for business to determine whether its profits are real or illusionary. Accountability to shareholders thus becomes more problematic. All these elements increase uncertainty, something that discourages risk-taking and investment.
Lastly, there is inflation's negative impact on employment, and therefore all the moral, social, and economic benefits accrued through work. Bureau of Labor statistics demonstrate, for example, that since the 1950s, periods of relatively high inflation in the United States have coincided with low employment-growth, while periods of relatively low inflation have corresponded with greater employment growth.
The reason is relatively simple. Inflation erodes the real worth of the capital accumulated by the private sector, banks, and financial institutions. The amount of real capital available for job-creating investments is thus reduced.
Inflation is thus more than an economic phenomenon. It strikes at the economy's ability to assist people to achieve their full human potential. Tough monetary policy is not just good economics. It's also an exercise in tough love, for all of us.
