Understanding Current Inflation and Its Relationship With Monetary Policy
Inflation — broad-based increases in prices across the economy — is unusually high, and consumers are concerned about the dollar's value. A paycheck or social security check does not go as far as it once did. The Bureau of Labor and Statistics states that within a 12-month window, inflation increased from 1.4% to 9.1%. What is causing the significant rise in price?
The answer is complex. Many things affect the inflation rate. While people are quick to blame pandemic shortages and international conflicts, which play a role, many economists argue the most significant influence is monetary policy.
What Is Monetary Policy?
Monetary policy is a combination of tools and actions to keep inflation in check while maintaining economic growth. The nation's central bank, the Federal Reserve, controls the overall availability of money to banks, businesses, and consumers. In effect, the Federal Reserve plays a more significant role in inflation than other factors, including pandemics and wars.
Other international factors contribute to domestic inflation patterns — supply chain disruptions, trade disputes, raw material shortages, etc. — but supply bottlenecks and foreign conflicts are not solely responsible for such a historic rise in domestic inflation.
The Federal Reserve maintained an interest rate much lower than in previous years, 2.33%, even as inflation rose to 7% and beyond. Currently, the bank raised the interest to between 3.75% and 4% in a tardy response to rein in inflation, consumer demand, labor shortages, and service industry struggles.
How Does Monetary Policy Influence Inflation?
Monetary policy and inflation have a symbiotic relationship when in balance. Unfortunately, an imbalance can cause current market conditions.
The Federal Reserve Bank controls the influx of cash into the economy. Too much cash adversely affects the dollar value, meaning money is subject to the same law of supply and demand as consumer goods. When there is too much supply, the value goes down, and when there is too little, the value increases exponentially. Finding equilibrium in monetary policy is challenging because of the various factors influencing supply and demand across the economy.
Monetary devaluation occurs when there is too much cash in the economic machine. If the supply of money is too high, its value decreases, meaning purchasing power decreases, causing goods and services to become more expensive.
What Are Cost-Push, Demand-Pull, and Built-In Inflation?
There are many forms of inflation — cost-push, demand-pull and built-in. The current economic problem is likely due to a combination of inflation forms. For example, the pandemic, international conflicts and material shortages reduced the supply of goods and services, resulting in increased prices — cost-push inflation. Also, material and labor shortages caused increased costs for each, resulting in demand-pull inflation.
Built-in inflation is a result of predicted inflation rates. The predictions prompt higher wages that also lead to higher costs.
While all these inflation theories help economists predict rises in costs, not all events are predictable. Supply and demand shocks and loose monetary policy can also influence inflation, and each likely contributes to the current economic climate.
Inflation is a natural part of any healthy economy. Unfortunately, it is susceptible to dramatic shifts like the country is currently experiencing. To control the damage, the Federal Reserve Bank needs to continue to make incremental changes, which will hopefully balance everything out.