Inflation And Today's Fed Move

Response to a couple of friends who asked for my view on the Fed's rate increase of 75bps today

The key thing to appreciate in regards to inflation, which is something that the media and even many economists don’t seem to understand very well, is that there is one and only true inflation: A decline in value of the unit of account—for us the dollar. In other words a rise in the general price level. That’s why a pedantic economist like myself hears people misusing the term such as saying “health-care inflation” or “higher-education inflation” as nails on chalkboard. The prices of things changing in relation to each other is not inflation.

More specifically, a change in the price of one good cannot by itself cause inflation, which should be obvious once we have a correct understanding of what actual inflation is.

An increase in the price of oil or wage growth, to name but two of many possible price increases, can be caused by and a part of inflation, but they are not themselves a cause of inflation.

Supply chain problems from COVID and COVID-policies are very real and problematic. And they have caused increases in prices—particular prices. But those are not inflation even though they appear as such in the statistics. They are markets equilibrating to new realities—specifically scarcity. That is why the Fed has been so reluctant to contract monetary policy. They believed these were just supply-side issues, which they cannot correct.

And in their slight defense the stats like CPI and PCE are polluted by both inflation and scarcity-induced price rises. However, they should have been following their own policy of flexible average inflation targeting (FAIT), which they have now abandoned severely damaging their credibility, as well as watching nominal GDP to see as far back as July 2021 that there was a significant and growing component of price data that was certainly real inflation.

They could also have paid attention to inflation expectations 2 years, 5 years, 10 years, and 5-years 5 years forward to see the market screaming at them that inflation was truly rising.

They have arguably only today begun actually tightening policy. The longer they’ve waited and continue to wait and the slower they go, the more they will have to do and the worse the potential outcome—specifically the more likely and severe recession risk becomes.