Inflationary Pressures and Economic Policies: How the Federal Reserve is Coping
Inflationary Pressures and Economic Policies: How the Federal Reserve is Coping
The global economy, particularly in the United States, has long enjoyed periods of low inflation and an abundance of goods to choose from. However, as economic variables continue to shift, we are entering a new era of inflation. This article will explore the factors contributing to inflationary pressures and how the Federal Reserve is addressing these challenges.
Understanding Inflation
Inflation, the general increase in prices and fall in the purchasing value of money, is a complex phenomenon. In the U.S., the Federal Reserve primarily monitors the Consumer Price Index (CPI), a comprehensive measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The CPI is used to fine-tune other economic series for price changes and to interpret indicators into inflation-free dollars. This blend of indicators provides a macroeconomic perspective on how purchasing power has changed over time, offering a clear picture of the change in the value of the dollar relative to the goods and services that can be purchased.
Contributing Factors to Inflation
The root cause of episodes of high inflation often lies in lax monetary policy. When the money supply grows too fast relative to the size of the economy, the value of the currency diminishes. Economists agree that there is a proportional relationship between excess currency circulation and rising prices. This relationship is at the heart of the Quantity Theory of Money, one of the oldest hypotheses in economics.
Lax Monetary Policy
In an ideal economic scenario, central banks use a target inflation rate to modulate economic growth, regulate the money supply, and moderate consumption. However, if inflation gets out of hand, it may indicate that the target inflation rate is not under control or that the commitment to the target is not strong enough due to political reasons.
Global Landscape
Low inflation and abundance of goods in the U.S. and globally can be attributed to sound economic policies and technological change. Technology has increased productivity, reducing the costs of inputs per unit of production. While most economies have flattened productivity gains, inflation remains low.
However, a new wave of productivity based on a “shared economy,” driven by international trade and other means of production, is contributing to the shift. Resources that were previously idle are now participating in economic growth, such as Uber’s car-sharing and Airbnb’s home-sharing models.
An aging population also impacts economic demographics, exerting inflationary pressure over both the short and long term. Globalization is further complicating traditional economic statistical metrics, requiring new methods to assess its effects on the shared economy.
The U.S. and Inflation
The extended period of low inflation and interest rates is drawing to a close as the accumulated effects of economic variables suggest that market expectations will soon manifest in price levels across the larger economy.
The shift is primarily driven by an increase in investors' expectations of future inflation. Evidence from inflation-protected bonds shows that investors currently anticipate an increase in consumer prices. The Trump administration's policies are likely contributing to this trend.
With largess in tax cuts and increased spending, the government will issue hundreds of billions of dollars in Treasury bonds in the coming years. To find buyers, the government must offer higher interest rates, resulting in increased interest payments. This economic reality must be addressed, and the Federal Reserve has to apply traditional economic equations to balance the budget.
The government must cover the primary deficit, which is the difference between non-interest spending and revenues, through new debt issues. In essence, this means adding new debt to cover the gap created by reduced revenue and increased spending.
No matter how economic policies are fine-tuned or the messaging to the public changes, the economic realities are inescapable. Inflation is a critical factor that the Federal Reserve must manage to ensure stable economic growth and financial health.
Conclusion
The Federal Reserve faces the challenging task of managing inflationary pressures while balancing various economic factors. Understanding the root causes, including monetary and fiscal policies, technological advancements, and demographic changes, is crucial for effective economic management.
As the U.S. economy enters a new phase, it is essential to recognize the complexities involved in maintaining economic stability and growth. The Federal Reserve, and indeed all stakeholders, must collaborate to address these challenges effectively.