U.S. Inflation Causes Cost and Prevention

U.S. Inflation: Causes, Cost, and Prevention

The concept of introduction, loosely defined is a drop in the value of money, or the goods being purchased for a certain amount of cash now costs more in terms of cash. This causes discomfort to individuals as they feel that they are 'paying more' for the same item. What they often fail to realize is that the emoluments have also gone up, and thus the general discomfort in paying that extra amount of money is notional.

Inflation in any country is created by the policies of the government and related financial institutions.

Inflation in United States

[TABLE HIDDEN]

(Inflation Rate in Percent for Jan 2000-Present)

From the table given above, it is clear that inflation in USA has been between the lowest limit of 1.07% a year in June 2002 and the highest limit of 3.73% a year during this period. In terms of trends there is no clear trend for the entire period, and even during the current year, though there was an increasing trend in the first four months, there has been a decline in May. In 2000, the measured inflation rose to a peak of 3.76%, then dropped and again reached a level of 3.73%. The entire period is full of rises and falls. However, there had been a rise for the period from January 2005 to April 2005. However, it is important to be accurate in observations of the data, and in many instances a calculation to 2 decimal places gives a finer picture than calculation to one decimal place as is in the statements of the government financial institutions. Naturally, this is a finer or more accurate view.

This can be seen in the case of January and February 2005 where the government index showed that both months had an inflation rate of 3%, but when one goes down to two decimal places, it shows that the inflation in January was 2.97% and the inflation in February 2005 was 3.01%. This makes it clear that during that period inflation had a rising trend. A similar example exists during August 2003 and September 2003 where the government index showed the inflation rates were 2.2% and 2.3% during the two months. Looking at that, one would say that the increase in inflation during that period was only of 0.1%, but when one goes down to two decimal figures, it shows that the increase was by 0.16%, and that figure is a lot more different from 0.1%.

Inflation -- Causes

Thus one can say that the main cause of inflation is the presence of excess money in the system. This time for inflation, part of the reason are the efforts of the Federal Reserve and their efforts to hold off a recession due to the effects of the terrorist attacks on 9/11 and the ending of the tech stock rises.

These were the reasons why they brought down the rates for overnight federal funds down immediately to 1%. This was followed up by President Bush with tax cuts in three efforts consecutively. The budgets that were passed by the Congress had very high deficits and the statutory debt limits went way above the figure of $800 billion and reached to the present figures of $7.38 trillion. The massive monetary and fiscal stimulus is very high for the system. To protect the system the efforts of the federal authorities have already started and they have raised the rates for federal funds to 2% so that the economy does not get overheated. At the same time, the Federal Reserve can act the other way should they want and in 1989 they had renewed their commitment to contain inflationary pressures.

At that time, they had raised the cost of money to contain inflation. The direct effects of inflation are clearly seen and the first of these are the fall of the value of the dollar against the other currencies. This has been reflected in the fact that value of dollar has fallen by 5% when compared to the Euro during the last three months. Another effect of inflation is that the employers start hiring and this process of hiring also increases the wages of the employees. This is seen in United States where the current unemployment rate in the country is at 5.4% now but there is increasing employment, and thus the country is getting to a situation of a tighter labor market. This is helping the labor, but at the same time, this is also increasing the supply of money and contributing to an increase of inflation. The final and important situation affecting inflation is the gradual increase in oil prices. This increase in prices is also a cause for inflation, but at the same time, there will be a time when the companies will start passing on these costs to the consumers.

That will negate the influence in increase of inflation.

Costs of inflation

The effects of inflation have been directly seen by the manufacturing industry and this is seen in the steep rise in the price of oil during the current year, and that has risen by a 150% during the current year. The manufacturers are trying to control costs and that includes efforts to keep prices at a low level. This is really difficult in a year when the labor market has become so tight. It has already been seen that Federal Reserve Board has increased the interest rates twice in their efforts to stop the growth in inflation. There have been increases in import prices due to the weaker dollar. This is not only leading to higher prices for items in electronics, cars and toys, and shoes, but is also helping the American companies to increase prices, but not control inflation.

The ill effects of inflation on the economy are well-known and there have been a great emphasis in recent years on the use of achievement of inflation targets as the main indicators for judging the success or failure of central banks and their control of monetary policy. While they are being judged, the new systems have also given these banks a lot of new methods through which they can reach this goal. Since the number of paths have increased, it is also clear that these organizations now have a lot of choice for the paths that they can take.

At the same time, inflation remains a problem for the public at large and has to be taken as a problem by the banks and not as a theoretical exercise. This should be taken separately from other paths of government like the fiscal policy to be adopted. The reasons for the choices made by institutions is often not so clear, and it is also not clear that the organizations responsible for inflation stabilization also have to take care of the fiscal policy and coordinate with the monetary authority for the complete choice and necessary action. It is true that for price stability there is a commitment to a suitable monetary policy and also a suitable fiscal policy. The theories of 'Ricardian equivalence' do not imply that fiscal policies are not relevant, except when the 'Ricardian policies' are concerned. Thus it is important to understand the role of fiscal development when a non-Ricardian regime is in operation and one of the illustrations of this is in the bond-support regime that was going on in the 1940s.

At the same time, it is often said that when disinflation is delayed, then the final cost of the process of disinflation increases. This is the view of experts of monetary policy. There are not many empirical studies that test this view of costs of disinflation. The experience now shows that delaying disinflation increases the output loss for every unit of reduction of inflation, and even this effect is not seen to be of statistical significance in all models. The biggest changes due to this delay take place when the inflation has just started and this can be attributed to the loss in credibility of the central bank which is in charge of the economy under inflation. This view has also been supported by the Board of Governors of the Federal Reserve system in 1994 through their statement "Countering [the] threat of inflation with more restrictive monetary policy could risk small losses of output and employment in the near-term but might make it possible to avoid larger losses later should expectations of higher inflation become embedded in the economy."

Thus what is required is a monetary-fiscal regime with attractive properties and this involves a monetary policy with a target for nominal increases in deficit as also a commitment for the fiscal policy. There are some theories for this view and the main support comes from two suppositions. The first of these is that fiscal policy has little significance in determining inflation and the second point is that monetary policy does not influence the government budget. The first point is considered as it is viewed that monetary policy is not an important consideration for the major industrial nations as the increase in revenues through monetary policy are low when compared to the total government revenue. This calculation neglects another result of monetary policy and that is the effect that monetary policy has on outstanding debt. This effect comes through the price levels of debt on future price level of the debt, and the future price level of the bonds. The effects are also through the reflected cost of interest for that debt, as this is affected by the interest costs that have to be paid.

It is also argued that inflation has no real influence on the demand of products from the consumers, and this should control the effect of inflation on the demand for goods. Yet fiscal shocks affect demand and these are the consequences of monetary policy on demand. The reason for this are the disturbances that are caused to private budgets through the change of prices, and these can be removed from affecting demand only if the government budget takes care of these disturbances which is not a practical solution. This can be affected only through fiscal policy, and thus the central bank has to determine the fiscal policy for the country to maintain a financial equilibrium. In simple textbook terms this can be stated as a process for countries with a strong fiscal position as fiscal exigencies determining the size of the real government budget deficit that must be financed; then this budget deficit is determined to the central bank as a part of the seigniorage revenue that it is created through the creation of money; and the increase in the growth of money will finally determine what the inflation will be and for this logic there are a number of theories.

Through these theories, it is clear that fiscal developments affect the rate of inflation in a country, and this happens only because they affect the monetary policy. This makes it clear that inflation still remains a 'purely monetary' phenomenon. This supports the view that when the government and the central bank are committed to an anti-inflationary policy then there has to be a suitable monetary policy to ensure price stability. At the same time, this is doubtful whether this theory will be applicable to a country as advanced as United States. It is said that these countries have an independent central bank and that does not have to accept the targets that are set by the Treasury.

Inflation also has a lot of good effects. An increase in inflation means an increase in wages and real estate prices. There will also be gains for individuals who have fixed rate loans which result in stable mortgage payments. This is a problem for lenders. They lend money in sums of hundreds of thousands of dollars, and due to inflation, the value of the repayments that are received by the lender decreases as the value of money itself goes down in terms of buying power. All bonds are also long-term loans and that is the reason why the bond markets are also hurt by inflation. Thus, when lenders feel that there is a likelihood of inflation, the lenders in the market start demanding higher rates of interest before inflation starts actually. These demands for higher rates ultimately bring the entire economy to a standstill as no development takes place due to the high cost of money in terms of interest rates.

Preventing inflation from taking place

Now let us look at the views of an expert, Alan Greenspan. He said in 1966 that "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. The abandonment of the gold standard made it possible for welfare sadists to use the banking system as a means to an unlimited expansion of credit (debt creation)."

He has said again before the Economic Club of New York City on December 19, 2002 that "It was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, has allowed a persistent over issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess"

The effects of his statements are quite clear -- he feels that the country has to go back to the level of backing up the value of dollars with gold. Certainly this cannot be viewed as a practical system in the present day world.

There have been also a lot of efforts from the different organizations, including the government. One of the important methods was to reduce the measurement methods for consumer price index in 1995. At that time itself, inflation was reduced from 3.1% to 2.8% due to the new method. Similarly for 1996, the figure was reduced from 3.4% to 3%. The statisticians in the Labor Department have quietly adopted this method and the results have been "Since the start of 1995, Labor Dept. statisticians have 'quietly' modified their treatment of rents, hospital prices, drugs, and altered other sampling methods. This has lowered the published rate of consumer inflation by 0.2 to 0.5 of a percentage point - and, a change of 0.63 points will be applied in 1998 and 0.75 in 1999 and forward. But, the govt. is not going back to fix historic data in the same way. Therefore, part of the apparent lower inflation rate numbers reported today compared to the past are from changing the yardstick of measurement."

This can certainly be viewed as a method of lowering the level of inflation as perceived by people, but not as the real effect on the levels of inflation.

Thus it is clear that inflation is happening and in the present situation, the individual has been left to himself. There is no great difficulty about the present situation for him as the salaries and job opportunities are likely to increase with inflation, but the greatest difficulties are in the area of investment. So far as an industrialist is concerned, he gains from the revaluation of his assets due to inflation, and the prices of his materials also increase due to inflation and there is no suffering that is caused through inflation. The difficulties due to the present inflation are with investors whose investments generally loose value with inflation. He has been given a new option in the inflation-adjusted Savings Bonds or I Bonds. These bonds yield 3.67% and they have a fixed 1% interest rate along with the inflation rate as measured by the consumer price index. Whatever adjustments have taken place to consumer price index cannot be reversed, but the new increases will be taken care of by these new bonds. The interest rates change every May and November for these bonds.

There are also the Treasury Inflation Protected Securities or TIPS. These also have been a fixed interest rate and the principal values change every six moths as per the inflation rate. The increases are taxed in the year that the Treasury credits the owner and for that reason it is better to hold them in tax deferred accounts like retirement accounts. These two accounts are able to take care of inflation and that is the reason why they have been launched. As in the case of other bond funds, the share prices of funds in TIPS rise when there is a drop in interest rates, but the prices will tumble if there is a big increase in interest rates without an increase in inflation. The only situation when this can happen is when the foreign buyers decide to buy less Treasury securities as those securities are used to finance the federal deficit. These bonds are also directly connected to CPI and when the oil prices increase, the returns from these investments will also increase.

These make it clear that the instruments are good for investment, and can be used by any person who is experienced in making money through funds of any type -- mutual or conservative bonds. They have been launched in January 1997. They generally have maturity dates of either five or ten years and the increases in inflation during this entire period are adjusted in them. Even when there is no inflation, and the prices of products are dropping, the principal values of these bonds will not decline below the par amount that is mentioned as was mentioned on the date when the bonds were issued. The interest that is payable on these bonds is guaranteed by the United States Government. This is the reason why these bonds have a high appeal to the conservative and savings oriented investors. According to critics the inflation adjusted bonds are complex and felt to be difficult to understand, and also difficult to sell before the maturity dates. This is probably the reason why they have not been very popular with the investors.