Does the Federal Reserve cause inflation?

[Common_Tater]

[QUOTE=pantom]
No, I don’t think so.
In another thread about the economy, I quoted an article that said that for the first time since the Depression, we’ve had two years in a row where the savings rate has gone negative. Like Ben Stein’s father said, things that can’t go on forever, don’t.
[/QUOTE]

But things can go on a lot longer than they “should” or have any right to. But why would anyone keep their money in “savings” when the interest income is low to nonexistent. CD’s, stocks, mutual funds, US index fund IRAs, municipal bonds, T-bills and even savings bonds don’t count as “savings”, do they?

[msmith537]

[QUOTE=BrainGlutton]

1. Does the Federal Reserve system cause inflation in the U.S.?

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No. There are several types of inflation:

Demand pull inflation – inflation from high demand for goods and low unemployment.

Cost push inflation – presently termed “supply shock inflation,” from an event such as a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

Built-in inflation – induced by adaptive expectations, often linked to the “price/wage spiral” because it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumers as higher prices as part of a “vicious circle.” Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

One role of the Fed is to keep inflation at a managable level through using interest rates to alter the money supply.

[QUOTE=BrainGlutton]

2. If so, is it the primary cause of inflation? Or even a significant contributing cause?

[/quote]

See above

[QUOTE=BrainGlutton]

3. If so, does it matter? That is, is inflation always a bad thing?

[/quote]

It’s bad for savings. People are less encouraged to save their money since it will be worth less in the future. In fact, one of the causes of inflation is the fact that $100 right now is worth more than $100 a few years from now (because there is a greater element of risk of the future money not being there).

The Fed tries to create a balance between growth and inflation. If the economy is too hot and grows too quickly, prices rise and we have inflation. If the economy is too cool, unemployment rises.

[QUOTE=BrainGlutton]

4. Could any modern monetary system function efficiently if its money supply were still based on the gold standard?

[/quote]

Probably a debate until itself but IMHO, no. It would unnecessarily limit your money supply and thus limit economic growth.

[QUOTE=BrainGlutton]

5. Is there any good reason to abolish the Fed and/or go back on the gold standard? (Something Ron Paul wants to do, apparently.)

[/QUOTE]

I don’t think so. There is nothing inherently valuable about gold other than the fact that people universally think it’s valuable. You could just as easily tie your economy to iron ore production. Instead, the money supply is tied to the value of the economy - our ability to produce goods and services.

[pantom]

Measure For Measure: Yeah, I do have to work on my humility, don’t I?*
BTW, I’ll take the bet on 2016. If something highly unusual doesn’t happen to the world economy by then, I’ll gladly eat crow.
Common Tater: as Sam Stone correctly pointed out in the thread about how the economy is doing, savings is calculated as spending minus after tax disposable income. This is subject to all kinds of distortions; a good article on this is at bankrate.com.
Me, being the optimistic SOB I am, would point to this passage:

Rather than looking at the savings rate as the amount consumers put away for a rainy day, an alternate but useful way to look at what economists call “savings” is to see it as a reflection of spending.
And in that interpretation, all economists agree: We are spending more as a nation than ever before.
In 2005, Americans spent a record $9.07 trillion, up 6 percent from 2004 when consumers spent $8.5 trillion.
Spending alone would not be a problem if incomes were keeping pace. In 2005, disposable incomes rose to only $9.03 trillion, compared with $8.68 trillion the previous year.
And if we look at spending as the economists do – as a percentage of incomes, we see that we have been spending a bigger and bigger percentage of our salary at the end of every month and have been doing so since the mid 1980s.
We are now at a point where we are spending slightly more than we are earning.
Where’s it all coming from?
Since our spending is outpacing our earnings, the money obviously has to come from somewhere. By definition, if you aren’t earning enough money to pay your bills, you are forced to either sell something, such as stocks, or borrow against something, such as a mortgage, to make up the difference.
And that is exactly what has been happening for the past few decades.

Optimists point to things like capital gains, but capital gains by definition are extracted from assets with some risk attached to them. The idea that the entire US can function as, in effect, a giant hedge fund is simply unsound. IMHO, of course. (Even if I am deficient in the ‘H’ part of that.)

*Of course, I made a few shekels back in the early 00’s from being the only sane person (!!) on the planet to correctly figure out that gold was going to go up and gold stocks be the best performing sector (which they were, for a couple of years there) once the dot.com bubble burst. I’ve been insufferable ever since.

[Measure_for_Measure]

@pantom

Yeah, I do have to work on my humility, don’t I?

As do we all, my friend. Actually though, your take has been reasonably nuanced.

BTW, I’ll take the bet on 2016. If something highly unusual doesn’t happen to the world economy by then, I’ll gladly eat crow.

Ok, but just to be clear: I’m in sync with your concerns about the US’s negative savings rate (when capital gains are ignored). I’m just asserting that we won’t get sustained core inflation above 5-6% without the acquiescence of the Federal Reserve. But if I misunderstand the nature of our economy, then I’ll be proven wrong. And I am expecting a decline --or crunch-- in the dollar. Something has to give.

Following up a comment you made earlier though, it is entirely conceivable that President Jenna Bush or whomever will try to inflate their way out of the US’s problems by appointing an accommodating Fed Chair.

@pantom

I think the above imbalances are precisely because you have the dollar as the world’s standard currency, the US gets to pay back its debts in its own currency without question as a result, and so it gives in to the temptation to just go as far into debt as it feels like, both in private through the current account deficit, and in public through the fiscal deficit. This is why you need something that isn’t a national currency as a standard.

This earlier quote is interesting. Permit me to riff off of it, giving a list of reasons why it is better not to tie the hands of the monetary authorities.

The government isn’t stupid
Oh yes they are: or rather, Congress and the Executive tend to be shortsighted. But they only affect interest rates indirectly, through appointments to the Federal Reserve. And its the Fed who would have its hands tied: I doubt whether those running fiscal policy would feel especially bound by a specie standard.

The rules are dumb
Tying the money supply to gold hands policy to Russian and South African mining authorities. More generally, the US and Britain had a bad experience with targeting the money supply in the late 1970s/ early 1980s.

Where the rules aren’t dumb, they are insufficiently flexible
Now I have some sympathy for nominal GDP targeting. But I could be wrong. For example, following such a rule means that the Fed should not worry about stock market bubbles, right? As it happens I believe that, but as a policy maker I wouldn’t want to commit myself to believing that indefinitely.

You’re barking up the wrong tree
Discretionary monetary policy has worked a lot better than discretionary fiscal policy. And it is the US fiscal (and savings) policy that’s really out of whack.

[pantom]

I realize that this thread’s about the Fed, however, I don’t really have much objection to what the Fed has done. Well, outside of that Great Depression thing, maybe.
I have my suspicions about Helicopter Ben, but Greenspan was remarkably good. Then again, you do know he was a gold bug, right? I have a feeling he was good because he had a pretty good idea of how to manage a fiat currency.
But the modern problem doesn’t lie with monetary policy, not anymore. The decision to go with a mildly inflationary monetary policy was made when the Fed was founded. Before that, we had a mildly deflationary monetary policy. An interesting distinction, but a businessman or a consumer can adjust to either environment as long as they know that it will last.
The problem begins and ends with the lack of a currency standard. The monetary authorities are left with the thankless job of cleaning up the mess.
The Chinese have made the collective decision to develop by lending us money, the Japanese have made the collective decision to do the same so they don’t have to tolerate immigration, among other reasons, and the US has made the collective decision that if foreigners are going to come with money, it will be spent, and damn the consequences. One need only look at the current account to see that this is the collective decision.
None of this would be possible if there were a neutral standard constraining all these actors, since a current account deficit such as the one the US has run up would have long since forced US interest rates sharply higher, which would have forced a recession severe enough to choke off the imbalance. This interest rate spike is what the Chinese and Japanese are preventing by soaking up the public and private debt issuances of the US. By now that recession would have been long since over, the imbalance corrected, and everyone would be just fine.
As it is, the imbalance just continues, and when it finally is corrected, the consequences will be far more severe than would otherwise have been necessary.
In much the same way that the Great Depression was far longer and far more severe in its consequences than any of the panics that happened before 1913. For some reason, that winds up as an argument against the gold standard, and in a crazy way, once the Fed is spanked for raising interest rates so that gold can be blamed for that Depression, for the continued existence of the Fed. I find that completely incomprehensible, but there you are.
Once the crisis does come, it will be seen as an argument for a world currency, a la the euro and Mundell. No one, or only a very few, will realize that a single world currency will only make the problem infinitely worse, since it will doubtless lack the interest-rate adjustment feature of gold that was regulated via its flows, which was regulated by the gold import/export points, and which therefore allowed growth to be regulated locally, and allowed the quick correction of imbalances.
We do need a world currency, but we also need local currencies, to allow local expressions of the money market’s supply and demand, through interest rates and currency fluctuations. Indeed, in the money market, as you doubtlessly know, interest and currency rates are so tightly tied up with each other that a plain vanilla currency hedge can be executed via either the money market or the foreign exchange market, interchangeably. This actually does happen in banks around the world, every day, and it happened in gold standard days every day, too.
But I can’t find anyone who can see the obvious, even among gold bugs, even though this was precisely how gold worked, and why the gold standard worked so well in its time.
I wonder sometimes. Often, actually.

[Measure_for_Measure]

[QUOTE=pantom]
The decision to go with a mildly inflationary monetary policy was made when the Fed was founded. Before that, we had a mildly deflationary monetary policy. An interesting distinction, but a businessman or a consumer can adjust to either environment as long as they know that it will last.
[/QUOTE]
I want to focus on this aspect, because I think our different POVs turn on it.

My lesson from the Great Depression and the Japanese experience is that deflation is an economic disaster: I confess that my attitude towards deflation borders on hysteria. If you agree with me, then it follows that a specie standard (or “basket of goods” standard) --which could lead to periods of deflation or inflation, depending upon conditions-- is a really, really Bad Idea.

Otherwise not though. It’s my burden to address the nineteenth century experience, where they had a few panics in the first half and a lot of them in the 2nd half. My take is that the labor market was a lot different back then, so that while deflation may not have been optimum, it wasn’t a continuous economic nightmare.

In a modern economy though, nominal wages are sticky downwards – they can be cut in a substantial way only through labor turnover, which means unemployment. But the latter can feed on itself – removing a demand management tool from the government is the height of folly (or rather, insert your choice of hyperbole here).

Now, to be honest, things might not be as bad as I conceive them. Actually, I understand that workers do accept nominal wage cuts under certain circumstances. Again, a really good study of the Japanese economic history, 1980-2010, would be illuminating.

---

Lesser points:

------ For some reason, that winds up as an argument against the gold standard, and in a crazy way, once the Fed is spanked for raising interest rates so that gold can be blamed for that Depression, for the continued existence of the Fed.

The Fed actually didn’t raise interest rates from 1929-33: rather Friedman and Schwartz criticize them for not dropping them with sufficient energy. There are a number of reasons for the Fed’s insufficiently stimulative policy.

1. No general model of the macroeconomy existed --anywhere-- prior to 1936.

2. They had to defend the gold standard (certainly true, but they arguably went overboard) and

3. (Friedman & Schwartz’s favorite) Benjamin Strong died. Ben Strong, former chairman of the New York Fed, was held in high regard by all and would have done the right thing. But after his demise, the Fed was run by a lawyer, more schooled in the art of compromise than in economics. So when times called for aggressive interest rate cutting, the Fed disastrously split the difference.

[pantom]

Well, I think we’ve pretty much exhausted this, but I do recall that somewhere in their writings Uncle Miltie & wife pointed out that the Fed could have been far more aggressive at the start of the Depression without at all violating anything about the gold standard. Friedman said as much in this interview :

And many people attribute it to over-acceptance of the idea of the gold standard. One of the explanations given for the Federal Reserve action was that they were tied to the ideology of the gold standard. The gold standard is not a limiting factor, and the Federal Reserve at all times had enough gold so they could have *maintained the requirements of the gold standard at the same time that they expanded the quantity of money. *

This has been, I have to say, an extremely enjoyable debate. Thanks.

[Measure_for_Measure]

I’ve enjoyed this discussion as well.

See my post #36 for some more recent evidence that the early 1930s Fed could have had a looser monetary policy, despite the gold standard.