November 20, 2021 / VOLUME NO. 184
What Really Causes Inflation?

The popular belief is that when it comes to inflation, perception is reality.

The story goes that inflation, or the sustained decreasing purchasing power of money, occurs because consumers believe prices will rise and then actively create the conditions to push prices upward. The economic narrative stemming from the 1970s sees inflation as a vicious self-fulfilling upward spiral: Prices are increasing, so people demand and receive higher wages, so businesses charge more for their goods. This continues until the Federal Reserve interrupts the spiral by spiking up interest rates, which is ostensibly a positive for bank margins but could put a damper on economic growth. 
Source: Screenshot of a video that was recently taken down off the Federal Reserve Bank of Cleveland Youtube channel.

Under this thesis, consumers’ current perception — or reality — is pretty bad. Public attitudes and outlook in early November registered at its lowest level in a decade — lower than at any point during the pandemic, according to the University of Michigan’s consumer sentiment index.

The survey attributed the drop to the “growing belief among consumers that no effective policies have yet been developed to reduce the damage from surging inflation.” 

But what if there’s an “equally if not more plausible” alternative explanation for what caused inflation in the ‘70s, asks a recent paper by Fed researcher Jeremy Rudd. He opens with the line: “Mainstream economics is replete with ideas that ‘everyone knows’ to be true, but that are actually arrant nonsense.”

Rudd critiques the models and evidence that led to the “dubious” current theory and proposes that businesses and workers consider the recent past, not a future forecast, to determine their prices and wages. The potential danger that comes from not understanding what drives inflation under the current theory is that central bankers, businesses and policymakers might create policies based on forward-looking surveys and expectations under the guise they can control the economy and ignore the actual data.

“By telling policymakers that expected inflation is the ultimate determinant of inflation’s long-run trend, central-bank economists implicitly provide too much assurance that this claim is settled fact,” he writes. “[I]n some cases, the illusion of control is arguably more likely to cause problems than an actual lack of control.”

Whether or not you agree with Rudd, it is worth considering the implication of this paper when the next consumer sentiment survey comes out.

• Kiah Lau Haslett, managing editor of Bank Director
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