What is inflation?

Jason Taylor, professor of economics at Central Michigan University, answers some of the most asked questions surrounding inflation, the Federal Reserve and the U.S. National debt. 

Adam: All right. I know that, right now kind of in the zeitgeist of the American economy, there's been a lot of discussion kind of exiting the pandemic about, about inflation, about interest rates and ultimately about the debt ceiling. I thought those could be kind of the topics we could brush on today and maybe give everyone a little bit of a better understanding about kind of what's happening around them in their world. I thought what would be really helpful was just to kind of set up a baseline for, “what is inflation?” 

Jason: Yeah. Economists like to say inflation is too much money chasing too few goods. So, if you can picture in your mind, maybe a wheelbarrow full of money, and on the other side you have maybe a wheelbarrow full of, of goods. And of course, we mean services when we say goods as well, but for the metaphor, think of goods. So, when you have more money and relatively fewer goods, it's gonna make the, uh, value of that money fall. In other words, you're gonna have inflation. Things are gonna cost more, it's gonna cost more to buy these, these goods. You're gonna have to have two pieces of paper for every, everyone to buy each good now, whereas maybe previously you had to have one. So, the cause of inflation can be two things. It can be you have this money pile growing while the goods pile is staying the same, or you could have the money pile staying the same while the goods pile is shrinking. 

In either case, you're gonna see a bigger pile of money relative to the basket of goods, and that's what the cause of inflation is. So, what we've seen with this inflation has been mainly caused a little bit of each, actually. So, you did have, with the pandemic, you had some supply shocks, some supply shortages, supply chain issues. So, the amount of goods shrunk a bit so that, so even if the amount of money had stayed the same and the amount of goods shrunk, you'd see a little bit of inflation. But on top of that, during the pandemic, we had massive stimulus policies. We had the Federal Reserve increasing the money supply by 40% over a two-year period, 40%, four zero. Um, so the amount of money grows significantly. This is a total recipe for inflation. We haven't seen this kind of inflation in 40 years, and lo and behold it did happen. We ended up having inflation peaking at about 9%, uh, last summer. Uh, and, and again, it's all because you had a combination. I think it was mainly growth in money, but also a little bit of a shrinking in terms of the amount of goods. 

How is inflation measured?

Adam: We see isolated examples of that, like eggs, right? Earlier this year, late last year, we were talking about, man, you should invest in eggs, not in gold, right? Like eggs went up 300-400% for a dozen eggs. Yeah, but that was directly a result of, uh, was it not, not salmonella. There was another disease, uh, avian flu. 

Jason: Yeah. So, understand that is not inflation. When we talk about inflation, we mean a general rise in the overall level of prices. And the way inflation is measured is the government takes a basket of goods and services that is representative of what a typical American buys. So that basket contains about 15% of that basket is food and beverages. Within that 15%, I'm gonna guess here, maybe a half percent is for eggs. It's probably even less than that. And then they have other parts of the basket to include. The biggest one is housing, which includes your rent that people pay, or their mortgages that they pay. So when, when any one good goes up in price or one service goes up in price, that's not what we really think of as inflation. Inflation is when the dollar loses its ability to buy all the goods and services in the economy because you have more dollars chasing relatively fewer goods 

What is the Federal Reserve and how did it come to be?

Adam: For a lot of people, myself included, like the Fed feels like this abstract. Right. Um, I was wondering if you could tell us a little bit about like what the Fed is and how it came to be. 

Jason: Sure, yeah. A lot of people might be surprised to know that the Fed has not always been around. It's not something that our founding fathers put into place. It was, it was founded in 1913 with the Federal Reserve Act, and it was founded because prior to that time, we had seen a wave of banking failures that had happened every 20 years or so. We had seen nationwide banking panics. And the idea was that the Fed would be like a, like a bank for banks, a lender of last resort. Now they've ref they reformed the Fed in the 1930s to give it more the look it has today. And since that time, the Fed has been much more in engaged in not so much the lender of last resort. That's part of what they do. But what the Fed is really thinking about now is trying to manage the business cycle, trying to counteract a downturn in the economy, for example, or trying to prevent too much inflation during a large boom in the economy. 

The Fed has a metaphorical printing press, and the Fed can, can put this money in the economy. And again, the way it does it is by buying and selling us government debt. That's how it changes the amount of money in the economy. So, when the Fed puts more money in the economy, it makes, it makes money less scarce, and therefore it lowers the interest rates that people need to pay to borrow money. Since money is more plentiful, it's easier for me to have access to it. It's easier for me to take out a loan and borrow money. A lot of big expenditures, especially by firms, but even by consumers, take place via borrowing. And they can be somewhat sensitive to the interest rate. If interest rates are high, 7, 8, 9, 10%, people are gonna be a lot. And especially businesses less willing to take out a loan to open up a new factory than they would be if the interest rate was 2-3%. 

Why does the Fed raise or lower interest rates?

Adam: The Fed has been raising rates since a little over a year now, last March. Um, and, and they continue to do so. And right now, we're looking at interest rates and the 5% range. Why, like, why right now do we still need those rates to go up? 

Jason: Yeah, so, so first of all, the rate that the Fed, the headline rate that you hear about in the news is an overnight rate. It's called the federal funds rate. It doesn't matter. It's not a rate that you or I would pay. It's an overnight rate, basically that banks would, would charge to each other if they were gonna borrow money. The key thing though is that the interest rates that you and I might pay, like the so-called prime rate, right? That banks charge their best customers tends to follow from the federal funds rate decisions of the Fed. So, if the Fed was to raise that overnight interest rate by a quarter percent, then the prime rate might also go up by about a quarter percent. It's not exactly a lockstep one-for-one. So, they cut rates to zero in 2020 as soon as the pandemic hit. I think they cut rates in March of 2020 down to zero, and kept them there until, as you said, about a year and a half until like 2022, early 2022. They started raising those rates again. And the Fed usually raises rates in small increments with the idea that they're gonna eventually get the rate up to their new target level where they're thinking. And of course, that rate now is up around a little over 5% now. And the theory is that by raising those interest rates, it will make money more expensive to borrow. It will then encourage less borrowing, less spending, and slow the economy down. Fortunately, so far, the unemployment rate has stayed relatively low. So very low, actually. It's the lowest it's been since the late 1960s. So, we haven't seen these higher interest rates have that negative macroeconomic effect, which is good news. 

How does the debt ceiling work and how does it impact the economy?

Adam: What are your thoughts about the, the impact of this debt ceiling and, and not necessarily like that, we're gonna go over that cliff because it seems unlikely, but like, what is the impact of kind of the system we have where we, where we even have a debt ceiling at all? Cause I think one of the things I found really interesting is, as far as western nations go, they don't have debt ceilings. It's kind of like us and Denmark. Denmark and that's it. Everyone else is kind of like, “ah, we don't do that.” 

Jason: Yeah. So, so other countries do have a debt limit that's related to their GDP. So that’s true, that the only ones that have a hard debt ceiling, like 31.4 trillion are the US and Denmark. But that's also a little bit misleading because other governments do have a debt ceiling. It's just done differently. You can't go over 80% of GDP as a debt or something like that, but nevertheless. And we're at like 126% or something like that. So, let's just talk about the debt for a second before we talk about the ceiling. Our national debt is, is 31.4 trillion is the, is the debt ceiling, and that's where we are. So, what is 31.4 trillion? It's such a big number, how do you put that? 

Well, our economy, we make about $25 trillion worth of stuff each year. So, our debt is higher than the amount of stuff we make in a year. Economists like to think of the, this is called the debt to GDP ratio. You take your debt, you divide it by your GDP and we tend to think that if that ratio is around 50%, you're good. That's fine. If you have a debt that's about half the value of your GDP. So, why is having a high debt a burden? Well, because you've gotta pay interest payments on that debt. This year, we're expected to pay $640 billion of interest payments on our $31 trillion national debt. $640 billion is a lot of money. The issue is that it's the look, looking ahead, it's not gonna get better because we have this demographic issue with the baby boomers and, we're kind of messed up in terms of our numbers, in terms of the amount of people that are young compared to the amount of people that are old. 

So, we made these promises to retirees for Medicare, social security, and as we get more and more people that we need to fulfill these promises to, we have fewer and fewer people down here paying into those systems. Too few people expected to be there to pay at the current rates. So, we're gonna have to either raise taxes significantly on the younger people, or we're gonna have to break our promises to the older retirees. Most economists would say, well, you know, let's not try to necessarily bring the debt down. Let's, if we can keep the debt at $31-$32 trillion while the economy grows, then we can get back to a more sustainable, you know, let's imagine that several years from now, we have a $50 trillion economy, not $25, $50, but our debt is, has been staying at, $30, $35, $40 trillion. 

Okay, well, then we're back to a little bit more sustainable where the economy has grown faster than debt. So, that should be our goal. 

Who holds the U.S. national debt?

Jason: There's a misconception that this debt is held by foreign governments, right? When I talk to my students, they tend to think this $31 trillion in debt is held by China. In total, I think, I think about $6 trillion of the debt is held overseas by foreign governments or foreign people. Yeah, about 20%. The vast majority, 75% of the debt is held by people like you, and it's held by people that have money in their 401k that have it in a bond fund. So, if we default on the debt, we're really defaulting on ourselves in a sense. And that's why I don't think that's gonna happen, politically, it's not a matter of just waving a hand and saying, you know, sorry, uh, other countries, we're not gonna pay you back. Much of the debt is held by American citizens, and they're not gonna be very happy if, if they're not receiving their interest payments or much less their principal back that they loan to the government. There could be one potential solution that I haven't heard people advocating for and a big part of the issue is that we have this demographic imbalance too. Few young people, too many older people. How do we get more young people? Well, one thing we could do is we could, we could open up immigration, legal immigration for people from all over different parts of the world that are in, say, their twenties, maybe early thirties, college-educated people. And, you know, and bring 'em in tens of millions. So, if a big part of our issue is we have too few young, too many old, you know, then we either need to have people have a lot more kids. But even that, there's about a 20-year delay between when the kids are gonna be in the - or we could bring in more legal immigration of people that are in their prime working years. 

What are good resources for economic information?

Adam: What is a good place that people can go to get economic information? 

Jason: I think one of the best places, honestly, is The Wall Street Journal. The Wall Street Journal, and CMU students and faculty have free access to The Wall Street Journal, CMU has purchased that site-wide. The Wall Street Journal has excellent reporting. When they talk about an article about things like inflation or the debt crisis, or unemployment or GDP or anything, they have long articles that they they'll of course use the old inverted pyramid where you start with the most important stuff first, but they'll get into many layers of, why is the Fed raising interest rates? What, what are interest rates? What is the gross domestic product? They always define it. And, I love it because when I teach economics, I'll often bring clips of these newspaper articles and highlight things and show my students, “Hey, this is exactly what we talked about in class. You know, this article is talking about what the Federal Reserve does, why it does what it does.” All this stuff is in the Wall Street Journal. I think the Wall Street Journal is a great, a great source to learn about the economics issues or The New York Times for that matter, or the Financial Times. There are a lot of good, good sources out there that, would be where I would recommend just reading. 

Adam: Professor Taylor was wonderful meeting you today. Thanks so much for coming in. 

Jason: All right. Thanks, Adam. 

Adam: I learned a lot today, so I, I actually really do appreciate it and it's gonna make me go double-check that my Wall Street Journal subscription is being paid for on my phone. I think it is. Apple doesn't let you stop paying, so thanks for that. 

Jason: All right. Well, thanks for having me here. 

Adam: Yeah. Awesome. Thanks for stopping by The Search Bar. Subscribe or follow the show so that you never have to search for the next episode.