We all understand inflation when we go to the store and see items we need jump in price.  What is less obvious is what the government tells us about inflation.  Last week they reported good news: inflation dropped from 5.4% to 5.1%.  These percentages were a "this month" to "last month" comparison.  Sorry — that is like saying your fever is down from 102 to 101 degrees.  You are still sick.  You are not well.  Nor is the economy.

A better measure is a year-over-year trend analysis, which shows we are far from getting inflation under control.

The methods used by government to determine inflation are extremely complex, often including surveys of "market baskets," and utilize many assumptions and subjective manipulations of data.  

Alternatively, you might just grab some bills and receipts for your housing, food, and gas for a couple of periods over last year and this year.  You will likely find that your costs have increased a lot more than Uncle Sam claims.  Don't kid yourself — we have significant inflation, and it doesn't appear to be abating.

The Federal Reserve has the responsibility to maintain stable prices with maximum employment.  To a degree, these goals contradict each other.  With absolute full employment, labor will demand higher wages because there are few people available for companies to hire.  This in turn will increase the cost of production, which will increase retail prices.

Congress has given the Fed many tools to use in achieving these goals.  The primary tools include changing interest rates, buying and selling securities, and modifying reserve requirements.

During inflationary periods, it is common for the Fed to raise interest rates.  The process starts with the Fed raising interest rates they charge their member banks (Federal Funds Rate).  This causes member banks to increase interest charges on loans they make, which increases the cost to producers, which increases the retail price to the consumer. 

Another method is to buy or sell securities.  The Fed conducts open market operations (OMOs) to purchase and sell Treasury bonds and certain other securities.  When purchasing securities, the money supply (cash in circulation and bank deposits) is increased by the amount of the Fed's purchase.  When the Fed sells securities, the money supply shrinks by the dollar amount of securities sold.  

The Fed can also adjust banks' reserve requirements, determining the level of reserves a bank must hold at the Fed.  Increasing requirements tends to reduce money supply, while reducing reserves increases money supply.

To encourage economic recovery following the banking crisis of 2007, the Fed initiated a program of Quantitative Easing (Q.E.) by maintaining low interest while increasing the money supply through purchases of securities.  During the COVID pandemic, the Fed stepped up Q.E. in a massive fashion, more than doubling the money supply from less than $4 trillion to over $8 trillion.

Was anyone in Washington aware of the fiscal dangers this might cause?  Or were people hiding in their basements, deathly afraid of a very infectious but relatively harmless flu-type bug?

Soon the Fed realized it was faced with a serious problem.  Too many dollars flowing through too few hands was causing significant inflation.  So the people running things began to increase interest (Federal Funds Rate).  It has increased from about 1.5% to over 4.5% today.   At the same time, the Fed began to sell securities to draw down the money supply.

Good luck, Fed.  The increased interest rates would normally help ease inflation.  But by 2022, the Fed had overdosed and doubled the money supply.  Trying to sell off enough securities to reduce the money supply to pre-COVID level is very tough, if not impossible.  

There are mostly storm clouds on the horizon.

Dann E. Kroeger, a common-sense everyday American. 

Image: Federal Reserve.