What Inflation Is, and What It Isn’t

It looks like we’re in for a bit of inflation. After decades of stable 2 percent inflation, the latest indicators say it’s moving up to about 4 percent. While fears of Carter-era stagflation are overblown, even a modest jump in inflation would be harmful. The warning signs are clear, and policy makers should act to avoid it. They probably won’t. Even so, a lot of people need to chill out on their inflation fearmongering.

We’re not going to become Argentina or Zimbabwe. We’re not even going back to the 1970s, when inflation was in the double digits. Part of the confusion is that many people seem to be confused about what inflation is, and what it isn’t. This post will try to clarify that in plain English.

The late Nobel laureate economist Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon.” That means inflation has to do with money itself. When the money supply changes, but the amount of actual goods and services doesn’t, the price level changes. This can happen when the government prints more dollars, adjusts interest rates on loans, and engages in heavy deficit spending.

Other types of price changes are not inflation. The recent hike in gas prices following the Colonial Pipeline hack was not inflation. That was supply and demand. The supply of gas was cut off, so its price went up. Since this didn’t involve the supply of money itself, it wasn’t inflation.

Computers are another example of non-inflation price changes. Most people are familiar with Moore’s Law, which states that computing power at a given price doubles every two years or so. On paper, this continual price drop looks like deflation. It is not. The price is going down because of technological improvements. Money supply has nothing to do with it. Again, if a price change isn’t monetary, it isn’t inflation.

Some of this confusion is baked into the indicators we use to measure inflation, such as the Consumer Price Index) and the Personal Consumption Expenditures Price Index. These take a basket of common goods and track their prices over time. While this is good for tracking overall price changes, they can’t precisely suss out how much of those price changes are due to monetary factors like deficit spending or dollar printing, versus how much is caused by non-monetary factors, like broken pipelines or technological progress. These indicators are useful and can give us a general idea of what is happening. But they are not perfect, and most economists believe they overstate inflation.

Many people are worrying about gas price increases as a harbinger of inflation. There is a psychological reason for this—for a lot of people, the oil price shocks of the inflationary 1970s are within living memory. Today’s shocks are bringing back some bad memories, and it is natural to make that association. But if it isn’t monetary, it isn’t inflation. The recent price shock was a supply and demand shock.

The rapid gas price increase also comes after people had gotten used to enjoying a year of low gas prices due to the pandemic. Coming up from a lower baseline makes a sharp increase feel even sharper. But again, this price change wasn’t monetary. People weren’t driving as much during lockdowns, so demand for gas was down. Money supply had nothing to do with it.

People shouldn’t be so jumpy, though it’s understandable that they would be. While 4 percent inflation is not cause for alarm, it will still cause harm. Inflation is a regressive tax that hits everyone, but especially the poor. When your dollars buy less for reasons having nothing to do with supply and demand, that is unfair—especially if you are already having trouble making ends meet.

Inflation also causes long-term harm. Prices are information signals. Even if people had no idea the Colonial Pipeline had been hacked, seeing a $16 per gallon price told them to buy less gas, and save supply for people who really need it. The hoarders the Internet has been making fun of are the exception, not the rule. Some of the images are also fakes.

Inflation messes with those signals. When a fake price signal tells people to buy one good instead of another, businesses will shift resources to meet that fake demand. That leaves everyone worse off—consumers and businesses alike. When people make long-term investment decisions based on faulty signals, the result is malinvestment—and fewer resources available for good investments.

How can policy makers keep inflation in check? One way is to spend less. When government engages in deficit spending, it increases the money supply. Part of the cost of the trillions of dollars of stimulus and infrastructure spending will be extra inflation—not enough to bring back bellbottom jeans, but enough to cause some harm.

Unfortunately, neither party is interested in spending restraint. Fortunately, even a $2 trillion infrastructure bill, if spread out over 10 years, will not have a major inflationary effect on an economy that is expected to produce more than $200 trillion over that time. It might be enough to add 1/10^th of a percentage point or two to inflation, depending on how other factors play out. But it is not enough to cripple the price system.

Another way to keep inflation in check is through the Federal Reserve. The best policy for the Fed would be to adopt a strict rule like the Taylor rule or Nominal GDP targeting. These work by giving the Fed set instructions on how to respond to economic conditions. A simplified version of how these rules work is that if the economy grows by a certain amount, the Fed increases money supply by a certain matching amount specified by the rule.

This would accomplish two things. First, it would keep the level of inflation relatively low. All else being equal, a lower inflation rate is better than a higher one.

Second, sticking to a rule would keep inflation predictable. That is more important. If inflation is stable, it can’t do very much harm, even if it is relatively high. People can plan around steady inflation by factoring it into interest rates and cost-of-living pay increases. But if inflation is jumping all over the place, how can a small business taking out a 10-year loan to pay for hiring and equipment calculate a fair interest rate?

While the Fed is unlikely to adopt a formal rule, it can at least resist political pressure to mess with inflation levels on election-minded politicians’ changing whims.

The recent news about inflation is not good, but it is also not apocalyptic. While inflation and monetary policy are a lot more detailed than described here, even a little bit of knowledge can show that while people should keep an eye on the new inflation, they also do not need to panic.