How to Stop Inflation

For many economists, the lessons on how to stop inflation were learned the hard way throughout the 1970s and the 1980s, when inflation peaked in the US at around 14% according to the CPI.

Unfortunately, it seems that those lessons have long been forgotten, and after several decades of irresponsible government spending with reckless mismanagement of the money supply, we are now set for an even tougher dose of economic reality in the 2020s.

The reader should be aware that none of this was preordained, inflation is a hallmark of incompetence and/or negligence, and the political elites whose policies have created it will seek to blame anything and everything rather than own up to their own shortcomings. Severe recession in the 2020s seems inevitable because there is little stomach in the western world to do what is needed to avert it.

In this article I will explain how to stop inflation, with both a modern history context and in the context of the 2020s.

How to Stop Inflation without Recession

For the most part, stopping inflation without a recession of some sort is usually impossible, but there are some circumstances that may permit it. To achieve this there has to be a period of rapid economic growth such that the supply of goods to the market can increase faster than consumers increase their demand for them.

This is not something that can easily be arranged, and in peacetime it would probably require a major technological advance in order to provide the impetus for a level of productivity growth sufficient to boost our way out of inflation difficulties.

One example would be the wholesale adoption of successful nuclear fusion technology, something that has the potential to provide abundant, ultra cheap, ultra clean, and ultra safe energy. As you can imagine, this is not the sort of progress that can be whipped up at short notice!

At the end of a major war there is often a significant inflation problem that has built up due to so many productive resources having been diverted away from producing consumer goods and towards military goods. When the war ends, assuming it ended with victory, there is usually massive capacity to redirect production back into consumer goods, thereby flooding the markets with extra supply.

This is not a situation that anyone would desire, and does not apply in peacetime, but it did play a very significant role in beating inflation in the 1940s without any recession in the consumer economy. There was, technically, a recession at that time because production of military goods does count towards GDP, and that production was halted with victory in Europe and Japan. Similarly, many ex-soldiers were made unemployed once the fighting stopped. This didn't last long though, and the consumer economy soon exploded into growth.

In the 2020s, the only hope of clearing the path for the sort of growth that could make a significant contribution to beating inflation is massive deregulation of the economy and severe cutbacks to most government programs. However, the sort of deregulation and cutbacks needed would be extremely unpopular at the ballot box, and is therefore highly unlikely to be adopted.

Even if they were adopted, it is unlikely that the necessary cutbacks would be enough to spur immediate growth, and thereby completely avoid recession. Cutbacks typically come with a 'sacrifice ratio' in terms of lost output relative to reduced inflation. However, they do at least reduce waste and lay the groundwork for a more speedy recovery.

Significant regulatory cuts might require the bulk of workers' rights and entitlements to be abandoned. Welfare payments would probably need to be drastically reduced, the freeing up of commercial land for development, the wholesale use of fossil fuels, a sizable extension of the retirement age, reduced pension entitlements, and much more needs to be on the table.

Many of the requirements would be highly undesirable and completely unfair, even immoral, but in the 2020s this is the reality of the situation that we are in after decades of incompetent profligate governments from both sides of the political divide.

Again, until the real pain of severe recession is really felt, and the impotence of government programs to solve anything is realized, it seems unlikely that the electorate will allow the sort of deregulation and cutbacks that are necessary to boost the real economy into significant growth.

Milton Friedman on how to Stop Inflation from Rising

The topic of stopping inflation, and how to do it, is closely associated with the work of Milton Friedman and his monetarist arguments. While monetarist doctrine during the years that Friedman was active did suffer from some inaccuracies (particularly with respect to its advocacy of targeting a preferred monetary aggregate), its main message is undeniably accurate i.e., that persistent inflation is caused by a growing money supply.

Friedman himself is on record as stating that:

Note the two elements to this message; both government spending and Federal Reserve money printing have the effect of increasing the money supply. Government spending need not necessarily boost the money supply, not if it is paid through taxation, but in recent decades there has been a persistent and growing budget deficit that has been financed by borrowing.

This is the cause of the massive increase in our national debt levels in recent years. Debt itself was misunderstood by the old school monetarists, but recent work by the economist John Cochrane of the University of Chicago (the university at which Friedman taught for many years) has shown that growing debt can be considered as growing money supply because both paper currency and government bonds (debt) represent liabilities of the Fed, and both are exchanged by the banking entities in settlement of outstanding balances.

Monetary Policy to Reduce Inflation

For readers who may be unfamiliar with the link between the money supply and inflation, think of it in simple supply and demand terms. If the Federal Reserve were to print $1m for every consumer in the US economy, what do you imagine would happen to the prices of goods and services?

With that much purchasing power, prices would immediately rocket higher. If prices did not rise, the demand for products would far outpace the available supply. Too many currency units circulating in the economy, relative to goods and services, means that prices will be bid higher.

Can the Fed stop inflation?

Via its operation of monetary policy, the Fed seeks to stop inflation from rising to a rate that it considers too high, and it does this by acting to contract the money supply. The standard approach here is to raise the Fed Funds Rate, which has the effect of pulling currency out of circulation and thereby slowing the rate of spending.

I have previously written about this in my article about the Quantity Theory of Money, and I'd encourage readers to closely study that article if a good understanding of money's relation to the price level and economic output is desired.

The key question to understand with regard to the Fed's ability to control inflation comes down to whether or not the economy can withstand higher interest rates without imploding in on itself. With debt levels so high, servicing those debts becomes increasingly difficult with higher rates, and it can easily create a liquidity crisis in the banking and finance sector.

When a liquidity crisis emerges because of rising interest rates, it is because of the inverse relationship between the market value of bonds & securities to the interest rate.

For example, if a bond pays a fixed return of $1,000 per year when the interest rate is 5%, investors will pay $20,000 to acquire that bond since $1,000 is 5% of $20,000. Now, if the interest rate is increased to 10%, that means that alternative assets will pay an investor $1,000 per year for only $10,000. In this scenario, the price of the bond must fall until its value matches its return.

The problem for the banking and finance sector is that, due to its enormous holding of bonds, a rising interest rate threatens to erode its assets to the point of insolvency. Any bank run at this point would threaten to destroy the system since the banks would be unable to return their depositors' money. Bank bailouts would then ensue, with massive expansion of the money supply in order to pay for it. That would undermine the initial interest rate rise and render the Fed incapable of stopping inflation from rising further.

How did Paul Volcker stop inflation?

Paul Volcker was the Chairman of the Federal Reserve from August 1979 to August 1987. He inherited a historically very high inflation rate that had risen for many reasons throughout the previous decade.

Excessive government spending to fund the Vietnam War, as well as expensive social programs in the 1960s, were partially to blame. In addition, the oil embargo placed on the West in response to its support of Israel during the Yom Kippur War in  the 1970s had caused the price of oil to quadruple, thereby significantly increasing the costs of production with inevitable consequences for the price level.

Luckily for Volcker, the outstanding US Debt to GDP at that time was little over 30 percent, around one quarter of its level in the early 2020s. The point is that, compared to Jerome Powell (the current Chairman of the Fed) Volcker had a lot more capacity to raise interest rates and bring inflation under control without causing an economic crisis of one sort or another.

Volcker raised interest rates to a high point of 19.1% in June 1981, and they stayed well above 10% for two and a half years. This was enough to bring inflation under control, but compare it to 2023 where a rate around 5% is enough to threaten a banking crisis.

How does raising interest rates stop inflation?

For a full explanation of the relationship between interest rates and the money supply, have a look at my article:

• Interest Rates and Money Supply

The key point to understand is that higher interest rates reduce the money supply, thereby reducing the level of spending in the economy, thereby causing economic output to fall (a recession) with reduced demand for goods & services relative to supply. That leads to a slowdown in price increases i.e. lower inflation.

Fiscal Policy to Reduce Inflation

Demand destruction, via a leftward shift of the IS curve in the case of fiscal cuts to spending, or a leftward shift of the LM curve in the case of tighter monetary policy, is the main vehicle for reducing inflation.

There is also a role for the restructuring of taxes into a less inflationary, and more production-friendly, format. For example, moving away from taxing firms for employing workers, and away from welfare payments for the unemployed towards in-work credits for those on low incomes. Both of these policies would work to maintain (or increase) employment rates by increasing both the demand for, and supply of, workers.

Fixing a high marginal rate of tax is known to reduce inflationary pressure from building up in the first place, because any excessive growth in income/spending resulting from unsustainable forces such as bubble markets, will be partially offset by the higher taxes. In other words, a high marginal tax rate reduces the marginal propensity to consume and thereby dampens the inflationary pressures of increased demand in the economy.

What else can Government do to Reduce Inflation?

Much of the effectiveness of government actions to reduce inflation comes down to the credibility of those actions in the eyes of influential economic agents. I've written about this concept in my article about Adaptive Expectations and how they influence the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The key point to note is that the expectation of future inflation does influence what the actual inflation will turn out to be.

With that in mind, it matters that banks, consumers, investors and other influencers in the economy believe that the government will stick to a stated policy when difficult circumstances require it. For example, sticking to spending cuts when the danger of recession is looming may or may not be deemed credible, especially if it threatens a loss of popularity among voters ahead of a general election!

The last types of action that the government can take relates to rent controls & wage and price controls. This occurs when the government directly intervenes in the market and fixes prices i.e. it makes it illegal to raise the price over a stipulated level.

Unfortunately, this type of action distorts market forces and leads to the formation of shortages, and it may even require rationing to be imposed. Any shortages of products will tend to lead to the emergence of black-markets on which prices end up even higher than if no price controls had been imposed. If followed for any length of time, these policies become increasingly toothless as buyers & sellers work around them.

Policy may be of a gradualist nature whereby a reduction in inflation is intended to unfold slowly over a number of years, or it may be of a cold-turkey nature, in which case a more sizable and immediate reduction will be intended. The cold-turkey approach is thought to be a less costly approach to stopping inflation in the long-run, but it will require tougher action in the short-run.

Sources:

• John H. Cochrane - Inflation and Debt (PDF)

Related Pages:

• What Causes Inflation?
• Demand Destruction
• Types of Price Controls
• Wage and Price Controls
• What is Inflation, and why is it Bad?

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