250 Billion Reasons Why the Fed Hates Inflation (and Doesn’t Care About Employment)

December 18th, 2011

Let’s start with the basics:

Increased inflation results in (in a sense, is) a wealth transfer from creditors to debtors.

Debtors get to pay off their loans in less-valuable dollars — dollars that can’t buy as much real-world stuff, stuff that humans can consume, that they value.

If you’re holding a hundred million dollars in bonds — you’ve lent out hundred million dollars — and bananas are going for a dollar apiece, an extra percent of inflation means that a year from now, you can only buy 99 million bananas. The people who borrowed the money from you get the other million bananas. If inflation stays up and the loan remains outstanding, they get another million bananas next year. You don’t.

You can start to see why creditors might be inflation-averse.

How big is this wealth-transfer effect? Here’s a quite conservative back-of-the-envelope calc.

Figure that there are somewhere north of $50 trillion dollars in private “credit market instruments” out there in the U.S. as of Q3 2011 ($120 trillion in total liabilities).

Do the math: 1% of $50 trillion is 500 billion dollars. One extra percent of inflation transfers that much wealth — buying power — from creditors to debtors. Every year.

This is probably an overstatement — many people/businesses are both creditors and debtors, so part of the transfer is from them to themselves. But still: let’s cut the number in half. An extra point of inflation transfers a quarter of a trillion dollars per year in buying power — real wealth — from creditors to debtors.

Because this effect impacts the huge existing stock of financial assets, 1. it is a permanent , and 2. its scale utterly dwarfs the relatively measly (and multidirectional) effects on flows — often second- or third-order effects — that (neoclassical) economists tend to go on about when discussing inflation. (“Money illusion,” “neutrality of money,” etc.)

And there are far fewer creditors than there are debtors. The effects of the transfer are concentrated on one side, diffused on the other. (See: Mancur Olson).

I’ll have a lot more to say about this in future posts, but keeping this short, I’ll bring it back to the the title of this post:

The Fed is run by creditors. And I’ve heard it said that financial incentives matter. The Fed governors have a huge incentive to keep inflation low, and ignore the other side of their dual mandate: employment.

We tend to talk in very big numbers these days, but a quarter of a trillion dollars a year seems like it’s still enough to get people’s attention.

Cross-posted at Angry Bear.

  1. December 18th, 2011 at 20:16 | #1

    Inflation aids debtors, deflation aids creditors – nicht wahr?

    You read that deflation levels wealth disparity, but that is a big red herring, I think.

    Deflation is is some way painful for everyone, but the pain is much greater at the low end of the economic spectrum.


  2. beowulf
    December 19th, 2011 at 11:50 | #2

    Interesting, considering that Congress defined full employment at 4% U3 rate and stable price level at 3% inflation in the Full Employment and Balanced Growth Act of 1978.

    Once both goals are met, inflation target shifts to 0%. in either case (before or after goals are met), inflation control policy is subordinate to full employment policy (“policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment”).

    So let’s unpack that. Instead of of using a 5.2% NAIRU, the CBO should use 4.0% as the full employment target when calculating potential GDP (making the output gap at least $300B larger than what CBO currently states). Using 3% as the inflation target (since they’re targeting 2% now) would be exactly the de facto 1% wealth tax Steve discusses above.

  3. December 19th, 2011 at 11:58 | #3

    What you said! Perfect.

  4. beowulf
    December 19th, 2011 at 21:36 | #4

    Thanks. To paraphrase Harry Truman, I just keep it real and they think its hell.

  5. Guido Travaglini
    February 26th, 2012 at 17:18 | #5

    This is why Greenspan in the late Nineties instilled in the nation the inflation scare, while actually the economy was deflating and enjoying a productivity hike due to modern technology. The upshot of this policy is now under the eyes of millions of new poors and laid-offs.

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