The current level of price inflation is crippling U.S. consumers. How and why did price inflation increase to such a great degree? What precipitated those events? Are you as curious as I about the mechanisms and decisions that lead us to this point of price inflation?
In this article, I’ll share my research into the topic. This will serve as a supporting piece to explain why we have seen the price inflation that I explored in the previous economic article “Inflation Narratives”.
Monetary Inflation vs Price Inflation
Let’s start with some initial definitions.
Inflate: to increase by a large or excessive amount.
Inflation: the action of inflating something or the condition of being inflated.
Typically, the media discusses inflation with respect to the rise in the prices for goods and services, or price inflation. However, there is a type of inflation that is a natural occurrence within the macroeconomy that involves increasing the amount of U.S. currency that is available in the economic system: monetary inflation. It’s monetary inflation that partially contributed to the recent trend in price inflation.
How is Money Inflated? A Guide to Money Creation
The money supply is inflated by creating more money. It’s that simple. The process of creating more money is more complicated.
Congress Controls the Purse
The Constitution of the United States of America at Article I, Section 8, gives the U.S. Congress the authority to both create new money and manage the country’s budget. Over time, macroeconomic complexities caused Congress to consider using a central banking system to manage the money creation duties.
The Federal Reserve Act
The United States suffered a stock market crash in 1907, and Congress lacked the tools to respond appropriately. By 1913, Congress passed the Federal Reserve Act, shifting the economy to function through a central bank. The central bank of the United States is the Federal Reserve System (The Fed). This banking system serves five major functions for the economy, as empowered by the act passed by Congress.
- Conduct monetary policy.
- Promote financial system stability.
- Supervise and regulate financial institutions.
- Foster payment and settlement system safety and efficiency.
- Promote consumer protection and community development.
Money Creation in a Nutshell
The Fed can create money and inject it into the economy in multiple ways and for multiple reasons. The Fed will order money to be printed by the U.S. Treasury when it is deemed necessary to add more physical money – denomination of U.S. dollars and coins – into the economy, to meet the need for demand from foreign investment or to replace the removal of unfit currency from the economy. Additionally, the Fed can initiate open market operations to create new money by purchasing treasuries and other securities from banks and other financial institutions.
The U.S. government may seem to create new money simply by printing U.S. dollars. However, that’s not quite what is happening. The U.S. government actually takes on debt to fund some of its fiscal needs by selling U.S. treasury bonds. U.S. Treasury Bonds are a type of security that is backed by the full faith of the U.S. government. That is to say that the confidence in the viability of the U.S. government to pay its debts, based on the nation’s economic strength, is the value upon which investors buy these bonds. These securities are sold onto the open market where they are purchased by the Fed, corporate investors and retail investors. The funds from these sales are then transferred into the U.S. government’s accounts and are available to use as new money. Additionally, treasury bonds have a set interest rate that is to be paid upon maturation of the bond. Therefore, the selling of these bonds by the government represents an amount of associated debt since the amount repaid will be greater than the amount received at sale.
The Fed – via the Federal Open Market Committee (FOMC) – typically creates new money by purchasing securities from the open market. The Fed purchases these items via a tool called open market operations. There are many types of securities on the Fed’s balance sheet, not just U.S. Treasury bonds. In exchange for the securities, the Fed transfers money directly into accounts at the banks and financial institutions that they purchase from. In turn, banks lend this money to individual entities – people and companies – who require new money via loans. These banks are able to loan out multiples of this new money based on the concept of fractional reserve lending, based on the reserve requirement. This means that the banks only have to have a fraction of the overall amount of money that they lend. For example, if the reserve requirement is ten percent, then a bank can lend out one hundred dollars with only ten dollars held in reserves.
Usually, monetary inflation does not cause runaway price inflation. Why? This is because the economy typically either grows or is managed for growth to stave off deflation. That’s why the Fed targets a certain level of manageable inflation.
The FOMC can also instigate currency creation via lowering interest rates. Lower interest rates means that borrowing money does not incur large interest charges during the life of the loan. This creates a stimulating effect for the economy. This causes people and companies to borrow more money for both investment and discretionary endeavors.
The economy could realize productive growth due to any combination of investment into either existing or emerging economic sectors and markets, continuous improvement of goods and services, or optimization of economies of scale by realization of reduction of unit costs supporting increased production. Consumers of the output of these growth areas will seek to access additional money in order to access these products. As more money is added to the system, there is increased demand created for the growing value and amount of goods and services. This increased demand usually results in higher prices, as more people vie to either acquire more goods or access additional services. However, this inflation is typically controlled. The rise in the prices is desired to be somewhat in line with the average rise in wages and asset values. This should maintain a relative balance of monetary throughput while the economy grows, allowing the majority of people to access a level of goods and services that is commensurate with their socioeconomic standing within the macroeconomy. In other words, the middle class can still afford middle class conveniences such as energy, internet, groceries, vacations, clothing, etc.
Why did monetary inflation cause what appears to be an imbalanced increase in prices as compared to the earnings of laborers? Let’s take a look.
Inflation Spark Starting in the Year 2020
In 2020, the United States had to respond to a global pandemic, alongside all other countries. As a result of social restrictions, many people were unable to work. Therefore, Congress passed legislation to allow for new money to be injected into the economy to support both companies and individuals who would not be able to earn revenue through the act of working and providing goods and services. This new money was meant to pay for essentials. However, it is believed that some of this money was used to purchase discretionary goods and services, driving up prices.
Let’s discuss three key contributors that have exacerbated the current inflationary phenomenon: 1) increased money injection, 2) supply chain disruption, and 3) pent up consumer demand.
Starting in 2020, the amount of money that was injected into the economy outstripped the actual value of the economy as measured by both GDP and the desired amount of inflation as a measure of economic growth. In 2021, price inflation followed behind monetary inflation, causing large spikes in the costs of goods and services.
Additionally, supply chains were necessarily shunted due to the aforementioned social restrictions. This caused a double whammy: there were no goods and services being created and distributed, and there was no fully functioning supply chain to deliver goods. This led to an additional drop in supply.
As stated previously, new money that is injected into the economy will cause monetary inflation. This will usually cause the economy to grow because there are more dollars being offered for goods and services, and producers typically scale up their offerings to meet this demand. However, when the amount of dollars injected outpaces the growth of both the combined number and value of goods and services available, demand typically grows faster than supply. More people have more money to offer for nearly the same, or lesser, amounts of goods and services. This will cause prices to rise.
Further, much of the money creation was orchestrated by the United States selling additional treasuries to both the Federal Reserve System and other private interests. This means that the U.S. government took on additional debt in order to provide the pandemic-era monetary infusion. In order to address these deficits, the U.S. will have to levy additional taxes, slash the budgets of social programs, or leverage beneficial arbitrage in foreign trade and investment, including international demand for U.S. dollars. Congress will likely implement a balance of all of those measures in order to mitigate the additional debt burden.
It’s also notable that interest rates were at some of the lowest levels in recent history. This made borrowing money both affordable and desirable. As mentioned previously, lower interest rates are one stimulant for economic growth, by reducing the cost of creating money through debt loans. However, and as stated before, this also requires the ability for producers and distributors to facilitate increasing amounts of goods and services to satisfy heightened demand.
As the world, and its markets, began to open up in 2021, many consumers and companies initiated spending. Due to lockdowns, there wasn’t an opportunity to spend money into disabled sectors of the economy. This created cash savings amongst many consumers. As the globe reopened, purchasers resumed normal levels of buying activity. However, the choked-off supply chain was still stunted. There was a necessary lag of several months required to spin both production and distribution back up to pre-pandemic levels. During this time, the overall consuming community had more discretionary spending capability than normal via both normal income and additional savings. Therefore, in addition to the input of extra money into the economy and the restriction of the supply chain, we also experienced pent up demand, in the form of savings stockpiled during COVID-19 lockdowns, creating an abnormally higher amount of dollars competing for a restricted amount of goods and services. This provided a perfect storm for rising prices.
The Fed began raising rates in order to slow down loan acquisitions, cooling purchasing by making it more expensive to borrow money and create new money from debt loans. Meanwhile, consumers have been faced with paying higher prices based on the amount of inflation that has settled into the economy during the inflation spike that started in 2021. Recently, the Fed has begun cutting interest rates again as a response to inflation falling closer to their target. The last rate cut was in December of 2024. Since then, the fed funds rate has held steady in a range of 4.25% – 4.50%. Only time will tell whether this move will spur on further inflation.
Conclusion
As we see, monetary inflation can lead to price inflation. This isn’t always a negative occurrence. When the inflation matches the necessary growth of the economy, the recognized price inflation does not outpace the inflation in the earnings of consumers and companies. However, acute, systemic disruptions such as the COVID-19 pandemic can send a shock into the system that requires a non-standard infusion of money into the system. These actions can create an imbalance in the levels of price inflation when compared to the inflation in earnings among consumers. At this point, price inflation strains the budgets of all consumers and can lead to further instability with regard to both macroeconomic and microeconomic concerns.
How have you been impacted by the current levels of inflation? Share your thoughts below.