Money Creation, Production & Inflation

Any time the Federal Reserve (the Fed) buys something, it prints the money to buy it. Contrary to what people think, the Fed doesn’t print currency. The US Treasury, their mint, does that. However, the Fed can print money electronically.

For instance, if the Fed buys my Honda for $10,000, all of a sudden tomorrow the statement of my account would show a figure $10,000 higher than today. The money is electronically put there and that is how it is “printed”. If we then look at the Fed’s balance sheet, you’d see my $10,000 Toyota added as an asset. Each week the Fed publishes its balance sheet or its list of assets, so we know how much money it has printed. Like I said, each time it buys an asset it prints the money to buy that asset. Typically the Fed buys securities, usually US Treasury bills, notes and bonds, and mortgages from banks.

From the time the Fed started in 1914 to 2008, its assets grew from $0 to $900 billion. That is how much money it printed in its first 94 years -- $900 billion or about $10 billion a year. From 2008 to the present, Fed assets have risen from $900 billion to about $4.2 trillion. Doing the math, the past six years it has printed more than 4 and ½ times the money it printed its first 94 years in existence. It has been wide open and it is printing about $60 billion a month now, buying Treasuries and mortgages. The Fed buys those securities from banks, mostly, so that new money is injected right into the banking system. Banks hold some of it or spend some of it, and the lend some of it to business or consumers for purchases. When that money is spent, it generates production or GDP and raises the prices of goods and services.

A simple example will tie together money growth, and the resulting inflation and economic growth. Let's say there are 10 hungry consumers and each has $1 each, and there are 10 oranges in the market. Each person will bid the price up to $1 per orange. OK, let's say the Fed all of a sudden doubles the money supply so the 10 consumers suddenly have $2 each.

What will happen? One of three things: The 10 consumers start to bid on the oranges. Prices start to firm and immediately the orange growers bring more oranges to the market (rising prices increase supply). If it is easy to create supply, in the end there will be 20 oranges, 10 people with 2 oranges each and the price of the oranges will remain $1 each. Doubling the money supply doubles output and the Orange GDP increases from 10 to 20 oranges with no price increase. Again, if it is easy to increase supply, money growth results in higher production.

Another possible result is the orange growers can not create more oranges, so each person bids up the existing 10 oranges to $2 each. No increase in output or GDP and inflation is 100% as the price of the oranges double. If supply is difficult to create, money growth results in inflation.

The other possible result is a combination of both. Money supply is doubled and the 10 consumers go from having $1 to $2. As they start to bid up the oranges above $1, some new oranges come to the market, let's say 5. In total 15 oranges get bought up with the $20 cash. Output rises from 10 to 15 oranges, but the price rises from $1 to $1.33 per orange. Typically, that is what happens. Money is printed, supply can be increased somewhat, but not immediately, and the result is rising output and rising prices.

A few things can moderate this. If the Fed prints a lot of money very fast, and it outstrips the amount of oranges that can come to market, the result will be more inflation and less output.

If there are a lot of oranges in storage (or slack in the economy), and the Fed prints money, those oranges will come out quickly, and the result will be more output and less inflation.

If consumers are fearful they can’t make their next mortgage payment, when the Fed prints money, consumers will hold the extra cash and not buy any oranges. The result will be output will not rise and the price of the oranges will not rise.

As I wrote above, the Fed has printed a ton of new money. What has been the result? A lot of the new cash has just been held. You have heard and read cash holdings of companies are at record highs. The consumer savings rate also rose as well. Just after the recession started neither businesses or consumers were confident so they just held the new money that was created.

Then as time passed, businesses started to invest their cash holding in stocks. This raised or inflated stock prices. To print the money, as I mentioned above, the Fed was buying mortgages from the banks. The banks naturally sold the Fed their lowest performing mortgages (loans that were likely to go bust). This cleaned up the books of banks and they started to lend in the housing market again. This increased demand for housing, and raised home prices.

With stock prices (401ks) and homes rising in value, consumers started to feel wealthy again and they started to spend on goods and services. As a result we are seeing more economic growth about 2.5% a year and more inflation. The question, and the point of this write-up is, how much is inflation rising?

The Consumer Price Index (CPI) is a government measure of the overall inflation rate or the rate prices are rising for goods and services. Over the years, the methodology used to calculate the CPI has changed. In the past it was a fixed basket of goods and services purchased by the typical consumer — clothing, food, medical services, housing, gasoline, etc. As the prices of the items in the basket rose and fell the index would rise and fall and the yearly percentage change was equal to the inflation rate.

Let’s assume our CPI contains only two goods (computers and steaks), and each is given an equal weight in the index. If the price of the computer was $100 and it rose to $110 over the year, and the price of the steak was $1 and rose to $1.10, both rose by 10%. Thus, the CPI or inflation rate would be 10%.

That is the way the CPI was calculated up until the early 1990’s. Then the government changed the calculation of the CPI. The new calculation factored in substitution and the concept of the fixed basket of goods was dropped.

Let’s say steaks rose from $1 to $1.10 or 10%. The government assumed less consumers would eat steak and purchase hamburger instead, so it would drop steak from the index (or lower its weighting). If hamburger rose from 50 cents to 52 cents, its price change of 4% would go into the index instead of the 10% increase for steak. This rolling down through substitution tends to understate how much prices are rising.

Let’s say in one year computers rose from $100 to $110 or by 10%. Let’s also say the speed of the computer rose by 6% over that 12 month period. In the government’s mind the consumer would be getting 6% more product at a 10% higher price, so the real price increase would only 4% for computers. Factoring in quality improvements tends to understate the inflation rate.

The new inflation rate states inflation is now rising at 1.5%. A website called www.shadowstats.com still calculates the CPI rate using the pre-1990 calculation. That old CPI puts inflation at 5% now.

Which is more accurate? You be the judge. Are the prices of the goods and services you buy rising 1% or more like 5%? Myself, what I see and feel is goods and services are rising about 5% a year.

Like most government economic indicators, I believe this one has been made more “rosey” too. Most government indicators these days tend to overstate output and employment and understate inflation. One, it helps at election time. If the unemployment rate is 6% under the new calculation, but 8% under the old calculation, which one will incumbents want published?

Two, the rosey indicators save the government money. For example, many government outlays are indexed to the CPI rate. Social Security benefits are increased by the inflation rate each year. If you are paying, and you want to pay less, you choose a CPI methodology that understates inflation. That’s was the driver here, I think when the government dumped the old CPI calculation.

The state of SC allocates education funding through various programs. One is Act 388, and the act allocates monies to school districts based on the district’s growth in population and the CPI rate. Like I mentioned, CPI is understated, thus, the allocation to school districts grows at an understated rate. This saves the state money.