On Inflation

The U.S. budget is at a concerning state as deficits and national debt are out of control. A deficit occurs when the federal government’s spending exceeds its revenues. As of this writing (July 2024), the federal government has spent $1.27 trillion more than it has collected resulting in a deficit. And, as of this writing US has approximately $35 trillion in debt. Majority of the tax revenue is eaten up by the interest payment which is not sustainable.

A deeper investigation is required in understanding how inflation can ruin society.

We all have a personal responsibility to investigate whether it is a political phenomenon, central banking phenomenon, or both? To what extent are interest payments eating up the national income? What major factors are contributing towards inflation? Which political party has caused the most deficit? What major events caused further inflation? What must be done to fix inflation? Why does a government operate this way when no household or a business would operate this way?

To answer these questions, we need to understand the basics and operating model of U.S. finances. Let's review them.

Who can print money? Federal Reserve Board which is the Central Bank of U.S. who has an authority to control money supply and interest rates.

What can they do with money? To purchase financial assets such as bonds.

Why do they do that? To support federal budget and the economic policies for U.S. Government.

The U.S. Government buy goods and services which then puts money in the hands of people. But when the government is in deficit, the U.S. Treasury can create bonds to borrow money which is then purchased by the Central Bank to fund the spending needs of U.S. government.

This is how both institutions work out their monetary (the Central Bank) and fiscal policy (the US government) out. More in detail below.

How does inflation come into picture?

Inflation occurs when the quantity of money increases faster than the quantity of goods.

Why does the money supply (print) increase? It does to enable the government to pay its bills without raising taxes. This causes psychological effect on people making them feel richer while the government debt grows. This is why it is difficult for government to reduce spending and print less money because this can cause recession.

The Central Bank has another tool in its arsenal which is managing interest rates to control the cost of money. The Central Bank can increase interest rates when the demand is high and reduce interest rates when the demand is low. This in turn would control prices and production of goods and services. If people feel the burden of prices they would consider reducing their spending which will result in less demand for goods and services.

The US government continues to finance its deficits by inflation which causes great prosperity for acting government but a great distress on its people. Inflation is a tax on its people. The purchasing power of each dollar will always be eaten up by inflation. No matter what the cause of inflation, it is not good for its people.

A deeper dive is required to understand the entire phenomenon. We'll review different types of cycles, policies, and how inflation has trended over time under each presidency.

Rather go to bed without dinner than to rise in debt. — Benjamin Franklin

The necessity for borrowing in particular emergencies cannot be doubted, so on the other, it is equally evident that, to be able to borrow upon good terms, it is essential that the credit of the nation should be well established. — Alexander Hamilton, 1st U.S. Treasury Secretary

Debt defines your future, and when your future is defined, hope begins to die.’ ... I’m not an anti-debt zealot. There’s a time and place, and used responsibly it’s a wonderful tool. But once you view debt as narrowing what you can endure in a volatile world, you start to see it as a constraint on the asset that matters most: having options and flexibility. — Kent Nerburn

As debt increases, you narrow the range of outcomes you can endure in life. — Morgan Housel

This is a great trap of the twentieth century: on one side is the logic of the market, where we like to imagine we all start out as individuals who don't owe each other anything. On the other is the logic of the state, where we all begin with a debt we can never truly pay. We are constantly told that they are opposites, and that between them they contain the only real human possibilities. But it's a false dichotomy. States created markets. Markets require states. Neither could continue without the other, at least, in anything like the forms we would rec­ognize today. — David Graeber

Deficit vs debt

The terms deficit and debt are frequently used when discussing the nation’s finances and are often confused with one another.

The national debt is the amount of money the federal government has borrowed to cover the outstanding balance of expenses incurred over time. In a given fiscal year (FY), when spending (ex. money for roadways) exceeds revenue (ex. money from federal income tax), a budget deficit results.

To pay for a deficit, the federal government borrows money by selling Treasury bonds, bills, and other securities. The national debt is the accumulation of this borrowing along with interest owed to the investors who purchased these securities.

The debt ceiling, or debt limit, is a restriction imposed by Congress on the amount of outstanding national debt that the federal government can have. The debt ceiling is the amount that the Treasury can borrow to pay the bills that have become due and pay for future investments. Once the debt ceiling is reached, the federal government cannot increase the amount of outstanding debt, losing the ability to pay bills and fund programs and services. However, the Treasury can use extraordinary measures authorized by Congress to temporarily suspend certain inter governmental debt allowing it to borrow to fund programs or services for a limited amount of time after it has reached the ceiling.

Since the United States has never defaulted on its obligations, the scope of the negative consequence related to a default are unknown but would likely have catastrophic consequences in the United States and all around the world.

Cycles

Economy goes through cycles. The deflationary cycle needs to be balanced with the inflationary cycle in order to maintain economic and social stability.

Inflationary cycle

When prices rise, we call this inflation.

As economic activity increases, we see an expansion cycle. Spending continues to increase and prices of goods and services start to rise. Prices rise when the amount of spending grow faster than the production of goods. Increase in spending can be fueled by credit which is created out of thin air (for example, in 2007 anyone could afford more than 1 house without enough income because banks lent too much money).

Increase in price causes a wealth gap making affordability a challenge for middle and lower class. People start working multiple jobs to meet their basic needs. They lose trust in acting government. Society runs into all sorts of crisis.

Deflationary cycle

The opposite is deflation. It occurs when prices fall.

If economic activity is decreasing rapidly, inflation is no longer a threat. Deflation can happen due to several reasons—exports (for example, goods from China), innovation (for example, computer prices overtime), lower wages or credit crunch (for example, the Great Recession of 2008 from mortgage lending).

Manufacturers slow down production. Lower production means unemployment. As prices fall and jobs are lost, people put off purchases. The stock market crashes. As economic crisis loom, government lose tax revenue.

A severe decrease in economic activity for a few or several consecutive quarters will cause a recession or a depression. For example, deflation helped turn the 1929 recession into the Great Depression.

Money

Now we understand the cycles, let's review the purpose of money in brief as it drives both monetary and fiscal policies.

Money fulfills three important functions:

• It acts as a medium of exchange.
• It provides individuals with a way of storing wealth.
• It provides society with a convenient unit of account.

The amount of wealth that the citizens of an economy choose to hold in the form of money as opposed to bonds or equities is known as the demand for money.

There are 3 basic motives for holding money—daily transactions, savings, and investing (speculation).

Through the Central Bank of Federal Reserve, the banking system creates reserves and money supply in an economy.

Policies

Government policies are responsible for spending behavior.

Government policy is expressed through its borrowing and spending activities. The two types of government policy that contributes towards economy activity are—fiscal policy and monetary policy.

The primary goal of both monetary and fiscal policy is the creation of a well-balanced economic environment where growth is stable and positive and inflation is stable and low. Both are used to regulate economic activity over time.

Both sets of policies are not interchangeable. They need to work together to meet their policy objectives.

Fiscal policy

Fiscal policy refers to the government’s decisions about taxation and spending to influence the economy. Fiscal policy drives the federal budget. The U.S. government consider its current economic cycle its in to drive spending and full employment.

The government has two tools while implementing fiscal policy. The first is collecting taxes on businesses, personal income, capital gains, property and sales transactions. This provides revenue for the government. The second is government spending which includes welfare programs, military spending, infrastructure programs, government jobs and other public projects. This puts money back into the economy which increases demand for goods and services while supporting employment.

Until the Great Depression of 1929, U.S. has followed the laissez-faire economic policies which is to not interfere with in a free market economy. Franklin D. Roosevelt (FDR) changed that by promising a New Deal to end the Great Depression. Roosevelt implemented expansionary fiscal policies by allocating government spending on infrastructure projects such as roads, bridges, and dams. The federal government hired millions of workers for these projects which put money back into the economy. In 1934 the economy grew by 10.8% which is shortly after the Great Depression of 1929.

There have been several laws passed since then to support the economic growth by cutting taxes or increasing spending to stimulate economy. Most recently, the CARES (Coronavirus Aid, Relief, and Economic Security) Act to provide emergency funding for small businesses and workers impacted by the COVID-19 pandemic.

Not so much of laissez-faire economic policies as U.S. government has played an active role in stimulating the economy. And, rightfully so as the government's primary responsibility is to maintain order in its society.

Every year the President of the United States kicks off the budgetary process, but Congress has the authority to approve the government spending. Revenue is generated by personal and corporate taxes paid each year. If the spending outpaces revenues, a budget deficit is created and added to the national debt. As of this writing US has approximately $35 trillion in debt.

Monetary policy

Monetary policy is set by Federal Reserve Bank. The Federal Reserve System is the central banking system of the United States of America.

The Board of Governors of the Federal Reserve System is responsible for setting up the monetary policies. One of the biggest parts of monetary policy is interest rates controlled by the Federal Reserve.

The primary objective of monetary policy is to control inflation to stabilize prices. The secondary objective is to stimulate the economy. Additionally, it is charged with the smooth functioning of the banking system. They are the lender of last resort to the banking center and the government. Hence, the Fed chair (currently Jerome Powell) is called the most powerful person on the planet.

To objectively implement monetary policy, the Central Bank should maintain a degree of independence from government. Furthermore, it needs to be credible and transparent in its goals and objectives.

The Central Bank doesn't want too much inflation because it causes problems. It raises interest rates when prices rise. With higher interest rates, fewer people can afford to borrow money. And the cost of debts rises.

Interest rates

The Central Bank sets federal funds rate to control inflation, money supply and use of credit. The banking system is guided by the Federal Reserve Chair.

The federal funds rate is the target interest rate range set by Federal Open Market Committee (FOMC) which commercial banks borrow and lend their excess reserves. Commercial banks cannot lend their entire reserve as there are regulatory requirements on minimum reserves.

When the economy slows down, the Fed has a tendency to cut rates as a way to make it more enticing to borrow money or invest. Businesses are encouraged to add jobs or invest more, and individuals may spend more or even borrow more money. Those things can spur economic growth. The downside is when the rate is too low, economic expansion can grow too quickly, causing inflation. This is when the Fed will raise rates to force you to not spend as freely, thus slowing down the rapid growth.

The fed rates also determine the interest rates of U.S. public debt. Just like with any personal loan, the lower the interest rate, the less the payment on the debt is. Lower interest rates mean lower debt service. The debt is basically an accumulation of budget deficits. That debt is currently around $35 trillion. Lower interest rate can reduce the interest payments for the U.S. government.

Additionally, interest rates influence purchasing power. As we know by now that interest rate is the cost of borrowing or return from lending. As the economy grows with inflation, the purchasing power of each dollar declines over time. This is the underlying principle of time value of money. You should always ask—how much of the interest’s purchasing power might be lost to inflation when investing or lending? If a bank charges 5% on a loan but does not consider inflation premium, the real return on the loan will be a lot less.

Lenders and investors can estimate the real rate of return by comparing the difference between a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS). Another way to determine inflation rate is by analyzing trend in Consumer Price Index (CPI), which measures the average change in prices paid for goods and services. This allows Fed to assess if there is an asset bubble. The CPI includes speculative things like commodities and food prices so the Federal Reserve uses a core inflation rate to measure it.

Money supply

Another tool on hand is quantitative easing (QE). It is a type of monetary policy by which the Central Bank tries to increase the liquidity in its financial system by purchasing long-term government bonds from that nation's largest banks and stimulating economic growth by encouraging banks to lend or invest more freely.

This needs to be deployed cautiously as it can have ripple effect on inflation due to increase supply of money in economic system. Most recently, inflation caused during the COVID-19 pandemic.

The central bank prints new money out of thin air to buy financial assets and government bonds. It happened in the United States during the Great Depression, the Great Recession of 2008, and again during the COVID-19 pandemic when the United States' central bank—the Federal Reserve—printed trillion of dollars to fix credit crunch. The central bank can print money, but it can only buy financial assets.

Can printing money cause inflation to rise? It won't if it offsets credit. Remember, spending is what matters. It doesn't matter whether you spend with credit or your money. Remember, inflation occurs when the quantity of money increases faster than the quantity of goods. By printing money, the Central Bank can make up for the disappearance of credit with an increase in the amount of money.

But money supply alone won't fix it. Income needs to grow faster than the debt growth to offset the balance and enter the surplus territory. If monthly income is $90.00, but the monthly debt is growing at $100.00, you are constantly running into deficit. Deficit is manageable if GDP is growing on a faster pace. If the debt-to-GDP ratio exceeds for an extended period of time, the deficit will begin to drag the economy down.

If income begin to rise, borrowers begin to appear more creditworthy. When borrowers appear more creditworthy, lenders begin to lend money again. Debt burden begins to fall. The economy begins to grow again, getting the economy back to the right trajectory of the long term debt cycle.

This is why balancing growth rate and interest rate is critical for policymakers.

Further reading