Inflation: Moving Beyond a Basket of Goods

Two topics dominate discussions of both the current state of the economy and the political environment in the run-up to the 2022 midterm elections: how can policymakers fight inflation and is the economy currently in a recession? Like everything else today, COVID-19 plays a role in the answers to both questions, but in this case the pandemic revealed a fundamental flaw in the metrics the Federal Reserve uses for monetary policy management.

The core of the problem is rather simple, the Federal Reserve carefully tracked inflation in goods, and as a result failed to see the runaway inflation in asset prices across the past four decades. Naturally, economists think of inflation in terms of the Consumer Price Index, or how much a basket of goods that the average American household buys regularly increased in price year-over-year. Prices have stayed fairly stable over the last forty years, rising slowly but surely at a reasonable and economically healthy 2%; all the while, the prices of interest-bearing assets have skyrocketed over the last four decades.

At the core of this increase in demand for interest-bearing goods is a rise in inequality. The deregulatory period of the ‘80s and concerted effort by conservative lawmakers and advocates combined to cause real wages to stagnate and income to concentrate to the highest-earning individuals. When real incomes increase, demand for goods and services increase because people can afford to buy more. When real incomes accrue only to the very wealthy, they tend to exhaust their demands for increased goods and thus seek opportunities for their wealth to grow faster. Consequently, we see a significant rise in prices for assets over the last 40 years and a relatively slow rise in the prices of goods and services. Recent events have only further proven this as the economic stimulus from the COVID-19 pandemic response measures represented the first significant change in real incomes since the ‘80s. This rise in real income led to a sudden demand increase for goods and services and the economy reacted with sudden rapid inflation.

Even when the Federal Reserve tried to create a new tool for fighting economic crashes, they further exacerbated the problem. In response to the financial crisis of 2008, the Federal Reserve created the concept of quantitative easing. The Federal Reserve bought hundreds of billions of dollars’ worth of assets to prop up market prices and ensure that banks’ balance sheets and aggregate demand for assets did not plunge when aggregate demand for assets should have cratered. The Federal Reserve worried far more about the collapse of financial markets than Main Street concerns. This action papered over what should have been a deflationary period for interest-bearing assets, but Wall Street had grown accustomed to these valuations and thus a return to more reasonable levels would have seemed cataclysmic instead of corrective.

Inflation as we see it today represents an indicator of a different dislocation in our economy: a forty year run up in asset prices beyond reasonable levels. Clearly there are two different causes: excessively cheap money because of excessively dovish Federal Reserve policy and increased inequality leading to asset demand far outstripping demand for goods. Either of these factors could have caused our current situation individually, but together they have created a house of cards economy that could correct fully at any time when the Federal Reserve’s interest rate and quantitative easing levers fail to meet the moment. The current inflation we are experiencing is just an odd symptom of a more structural issue. To address these issues, the Federal Reserve first must rethink the measures they use to decide the money supply. Inflation and employment have obscured the low increase in purchasing power of middle quartile Americans over the last four decades. Unemployment may be low now, but many Americans need to work more hours and can afford fewer goods than their parents’ generation. So instead of measuring if enough Americans have a job or if the goods that they can buy with their wages are increasing in price, measure if the basket of goods that a 40-hour work week can buy is increasing in value. Let that dictate money supply. Indeed, this will also address inequality. Minimum wage, bargaining power, and taxation policy must all focus on growing what the median work week can buy. This way we will address both the input and output of the equation as opposed to focusing on stock markets or employment numbers. The core question is what a reasonable work week can buy. That is a number that we must focus on increasing, or else what is progress really for.