Over the last 40 years, monetary policy has caused interest rates to decline from a high of around 20% down to the zero bound. During the same period, the US dollar (USD) money supply has expanded at a rate never before seen in modern history and asset prices in dollar terms exploded to the upside, all while the US average hourly wage has lagged on an unprecedented scale.
Ironically, the growing wealth gap, caused by lagging wages and rising asset prices, has occurred while the Federal Reserve (Fed) has been targeting a 2% inflation rate and pushing the narrative that inflation is good for the economy, good for economic growth and most of all, good for the average Joe. This makes us wonder why the Federal Reserve, through monetary policy, is adjusting interest rates and setting inflation targets and whether this intervention is really benefiting the economy.
To start, let’s focus on the question: why are we seeing this intervention from the Fed? The US has a total debt to GDP (Gross Domestic Product) ratio of 257%¹. This fragile debt house of cards, which the Federal Reserve has created, has caused them to fear deflation and its effects on the economy. The Federal Reserve is then essentially forced to intervene so that they are not perceived as the ones allowing the economy to collapse. They do this primarily through the lowering of interest rates and through inflation, or in other words, a debasement of the currency through an expansion of the money supply. This intervention leads to an increase in consumption, asset purchases and mal-investment, which in turn leads to an ever-increasing debt burden and therefore an ever greater deflationary headwind on the economy. The cycle then repeats itself with the Fed having to intervene time and time again. The Federal Reserve is stuck in a negative feedback loop which they themselves have created.
What are the side effects of inflation?
First, let’s look at the effects of inflation from the consumer perspective. Let’s imagine for a second that the government suddenly doubled the total supply of dollars in the system. In theory, everything would double in price as the value of the currency would be halved. Now, the producers of a product or service essentially have 3 options:
They could double the price of their product or service to maintain their current margins. The side effect of doing so is that they will most likely drive away customers.
They could maintain the current price. The side effect of doing so is that they will take a hit on their margins and therefore their bottom line.
They could maintain the current price, but reduce the quality of the inputs which make up their product or service. The side effect of doing so would be that they would provide their customers with a lower quality product or service, but maintain their margins.
What tends to happen is that the producer chooses either option 1 or 3 in order to take the path of least resistance and reduce a potential hit to their bottom line. We therefore have this byproduct of inflation whereby the producer now has to either raise the price of the product or service or deceive the consumer by lowering the quality of their product or service. Both of which leads to the consumers losing out.
Second, let’s look at the effects of inflation from an asset perspective. As inflation devalues the currency’s purchasing power, it causes both the price and demand of assets to increase, which in turn artificially increases scarcity. This creates knock-on effects in the form of conflict and social unrest, as disputes arise over ownership of assets. Monopolization then tends to ensue in order for those in power to maintain control due to the increasing scarcity and price of assets. We then have the bigger issue, whereby huge wealth inequality between the holders of these assets and the holders of the currency starts to appear as the currency loses purchasing power. This can be seen in the lagging average hourly wage in relation to assets in the chart below.
What’s worse, is that over the last decade this lagging of wages to asset prices has only increased (as shown in table 1 under the Jan 2010 — Jan 2021 column). This has caused one of the greatest transfers of wealth from the lower class to the upper class in recent history.
To play devil’s advocate, when inflation was initially implemented, the central banks had good intentions. Inflation in the form of monetary expansion, or interest rate adjustment, is a way for the Federal Reserve to attempt to dampen short term volatility by stimulating the economy in times of stress. However, the issue is that volatility is just energy, which as we know from the first law of thermodynamics, cannot be destroyed. Instead, it is just transmuted, and so by trying to prevent/dampen short term pain in the economy, this instead delays the pain and amplifies its future effects. This is why the initial bump in debt, in the form of monetary and fiscal stimulus in times of stress, evolves into this beast of constant debt expansion in order to prevent economic collapse.
Read more: Sebastian Bunney