Inflation and Federal Government and Opinion and Economic Analysis and Economy and Government & Economic Development

HICKS: Courage will be necessary to curb inflation

March 6, 2010

The most recent inflation report was frightening. The annualized estimate of inflation was in excess of 15 percent. Within the hour, mortgage rates jumped 20 percent and the Federal Reserve increased rates on short-term loans to banks. Scary stuff.

The good news is that the core rate of inflation (excluding fuel and food prices) was just under 5 percent annually. So, despite the immediate scare, there is some time, six to nine months perhaps, before the Federal Reserve will have to start raising the federal funds rate to ward off inflation. The danger is that this will come before significant job creation, prolonging high unemployment.

Many ask, why should we be worried about inflation? Inflation is often thought of as a rich man’s problem. In the short run, it is. Inflation reduces the value of savings, transferring wealth from the lender to the borrower.

So, if you have a big house or car payment, and no savings, inflation may be a welcomed thing. If you have no debt, and much savings, inflation is simply a penalty on your thrift. But, in the long run, inflation causes lenders to raise interest rates. Businesses slow their borrowing, produce less and require fewer workers. Within a year or so, inflation becomes everyone’s problem.

Over a year, 5-percent inflation is a bit worrisome, 7 percent or 8 percent is a borderline national emergency, and 15 percent endangers the Republic. The happy news is, we will not have a year of even 7-percent inflation. The Federal Reserve will not allow it, as it is obliged by law to maintain price stability. An increase in interest rates will prevent any such risk. The sad news is, any such increase will cause unemployment to remain high, or perhaps grow. The terrible recession of 1981-1982 came about this way.

So, the conundrum is, how do we prevent inflation?

Let me clarify, inflation is everywhere and is always a result of too much money chasing too few goods. The growth in the supply of money in the past 18 months dwarfs all other such episodes in the United States (even when adjusted for inflation). We also have the largest (in inflation-adjusted dollars) growth in the U.S. deficit outside of the Civil War or World War II. And though it puts me in a minority, I agree with Paul Krugman, that the size of the debt is not as yet a problem. The rate of its growth is.

Ignoring the stimulus and bank bailout, the federal deficit has grown by double digits over two years. This sends a strong signal that the deficit will be a permanent policy. Spending must be deeply cut, especially in areas where the stimulus remains unspent. Taxes may need to rise.

Both acts will kill jobs, but prevent inflation. This will demand courage in the House and Senate—a commodity that is not in oversupply. Failure to do these things will have unhappy results: inflation and a slowing economy. In the end, inflation is simply a tax on the cowardice of Congress.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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