Inflation: Democracy's Silent Partner

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• Inflation has been a silent architect of American democracy since the nation's founding, shaping economic policies and political movements.
• The Federal Reserve's role has evolved dramatically, from crisis manager to inflation targeter, reflecting changing economic priorities and understandings.
• Political affiliations significantly influence inflation expectations, challenging traditional economic models and policy-making approaches.

When you think about the cornerstones of American democracy, what comes to mind? The Constitution? Voting rights? Freedom of speech? While these are undoubtedly crucial, there's another force that has been silently shaping our democratic landscape since the nation's founding: inflation.

"Inflation has really been part of the fabric of economic debate in the U.S. right from its founding," explains Dr. Carola Binder, Associate Professor of Civic Leadership and Economics at the University of Texas at Austin. She challenges us to view inflation not just as an economic indicator, but also as a fundamental element intertwined with the very fate of our democracy.

But what exactly is inflation, and why has it been so pivotal in American history? At its core, inflation refers to the rise in prices of goods and services over time. However, its impact reaches far beyond the cost of your morning coffee. Throughout U.S. history, inflation has influenced political movements, shaped economic policies, and even altered the balance of power between different social groups.

From the early debates about currency to the establishment of the Federal Reserve and the implementation of modern monetary policies, inflation has been a constant force in shaping economic thought and policy decisions.

Understanding inflation is crucial for every citizen because its effects touch every aspect of our lives, from the value of our savings to the cost of our loans, and even influence how we perceive our political leaders.

As we explore the historical context, measurement challenges, and future trends of inflation in American democracy, we'll uncover its hidden influence on the world's oldest continuous democracy.

Historical context of inflation in America

In early America, the concept of inflation differed significantly from our modern understanding. Instead, early Americans observed price changes in individual goods and commodities.

The absence of a centralized system for measuring inflation didn't mean its effects went unnoticed. Farmers and traders were acutely aware of price fluctuations, particularly in crops and farm goods. These prices, often set on global markets, were influenced by conditions both in the U.S. and its trading partners' economies.

A key debate in early American economic policy centered on the choice between paper money and the gold standard. This debate embodied deeper tensions about the nature of currency and its relationship to value. Andrew Jackson, known for his populist approach, was "a really staunch supporter of hard money," according to Carola. The Jacksonian Democrats viewed gold as a way to protect common citizens from the potential instability of paper currency.

Later, figures like William Jennings Bryan, also claiming to represent farmers and common people, advocated for a more flexible monetary system. This shift reflected changing understandings of how currency policy could affect different groups in society.

The impact of inflation (and its counterpart, deflation) on various socioeconomic groups was profound. Carola points out a crucial dynamic: "Deflation makes you worse off if you're a debtor, inflation makes you better off." In an agrarian society where many farmers were in debt, these monetary fluctuations could have significant consequences.

Periods of deflation, often following wartime inflations, were particularly challenging for debtors. As Carola explains, "If there's deflation, prices fall, and you have a nominal debt, that increases the real value of your nominal debt. So it makes you worse off." This economic reality fueled political movements like the Granger movement, with farmers demanding policy interventions to address their economic struggles.

The evolution of central banking

The establishment of the Federal Reserve System in 1913 marked a significant turning point in America's approach to monetary policy and inflation management. However, as Carola points out, the Fed's initial purpose was quite different from its current role: "The Fed was really more constructed as a lender of last resort to help deal with financial crises and also to provide elasticity in the currency."

This original mandate reflected the economic challenges of the early 20th century, particularly the need for a more stable financial system following recurring bank panics. The Fed's role in managing inflation was not explicitly part of its initial charter.

The evolution of the Fed's responsibilities came gradually. This elasticity was crucial in an economy where seasonal demands, particularly in agriculture, created fluctuating needs for cash at different times of the year.

"It wasn't actually until the inflationary episode of the 1970s that we finally got an explicit mandate for the Fed to control inflation," says Carola. This change represented a fundamental shift in how policymakers viewed the role of central banking in managing the economy.

The move towards prioritizing price stability was not without controversy. As Carola explains, "During wartime, there wasn't really any move to say, let's have the central bank stabilize prices. It was just the opposite. It was like, we need to just keep interest rates low."

Central bank independence also emerged as a crucial aspect of monetary policy. Carola emphasizes its importance: "We have federal reserve independence, right? You do see the Fed and other central banks under a lot of political pressure for looser monetary policy. Luckily, the Fed seems to be able to resist that kind of pressure."

This independence allows the Fed to make decisions based on long-term economic stability rather than short-term political pressures. However, it also raises questions about the balance between technocratic control and democratic oversight in managing something as crucial as the nation's money supply.

"The monetary arrangements we have now are not really democratic in the sense that our elected officials don't vote on monetary policy," says Carola. "They recognize that that's not really democratic, but that if we did have democratically elected officials responsible for monetary policy, it would probably lead to a lot of inflation because politicians would be more short-sighted."

Measuring and interpreting inflation

Measuring inflation and understanding how the public perceives it is critical but complicated. Carola's research sheds light on the challenges and nuances involved in this process.

The primary tools for gauging inflation expectations are surveys, primarily the Michigan Survey of Consumers and the Federal Bank of New's Survey of Consumer Expectations. But interpreting these surveys isn't straightforward.

Carola points out a significant issue: "They ask what do you expect inflation to be over the next 12 months or what do you expect to happen to prices in general over the next 12 months? And people give a number. Can we actually interpret that as inflation expectations?"

This ambiguity in interpretation is further complicated by recent findings about the impact of political affiliations on inflation perceptions. Carola's research revealed a striking phenomenon: "There's this huge divergence between Republicans and Democrats inflation expectations, especially in the Biden presidency."

“Normally, people who support the president have lower inflation expectations, and people who are of the opposite party have higher inflation expectations,” says Carola. “And that's still true, but the gap just widened so much that during 2021-2022, when inflation was rising, Democrats' expectations didn't budge. And the whole rise in expectations came from Republicans."

This political divide in inflation expectations raises questions about how accurately these surveys reflect genuine economic forecasts versus political sentiment.

Despite these challenges, understanding inflation expectations remains crucial for policymakers. Carola notes, "People are much more aware of inflation now and kind of likely to be sensitive to it." This increased awareness can impact economic behavior and, in turn, actual inflation rates.

The concept of "anchored" inflation expectations is particularly important. When expectations are well-anchored, it means the public generally trusts that inflation will remain stable and close to the central bank's target. However, recent experiences have shown how fragile this anchoring can be.

"Even though inflation is back down, you also hear the story that the price level itself is not back down,” says Carola. “So people feel like inflation is high." This perception gap between actual inflation rates and the public's experience of price levels presents an ongoing challenge for policymakers and communicators.

The future of monetary policy

Nominal GDP targeting has emerged as a potential alternative to the current inflation-targeting framework. Also described as a nominal income target, nominal GDP is the dollar amount of goods and services produced in the U.S. every year.

"So if inflation is 2%, real GDP — the amount of actual stuff we produce — grows by 3%,” says Carola “Then nominal GDP would grow by 5%. So the idea is you target some path for nominal GDP, and maybe it's 5%."

The appeal of this approach, according to Carola, lies in its simplicity and potential to resolve conflicts between different policy objectives. "When the Fed has two targets — a price stability target and an employment target, there's trade-offs between those two," she notes. "If they have a nominal GDP target, it's essentially telling them how to balance those objectives."

However, implementing such a policy is not without challenges. "There's always information problems in monetary policy,” Carola points out. “Monetary policymakers have to set their policy despite a lot of unknowns — what's the natural rate of unemployment? What's the neutral rate of interest? Is the inflation that we're experiencing mostly demand-driven or mostly supply-driven."

The debate over incorporating asset prices into monetary policy considerations is another area of potential future development. Many economists, including Carola, are uncomfortable about the central bank targeting relative prices rather than aggregate prices.

Ultimately, the future of monetary policy will require adaptability and innovative thinking. As economic conditions and our understanding of inflation dynamics continue to evolve, policymakers will need to remain open to new approaches while carefully considering their potential impact on both economic stability and democratic principles.

The pulse of democracy: Inflation's enduring impact

From early debates on currency to modern discussions on central bank policy, inflation has shaped our economic landscape and political discourse and has been closely intertwined with public perception, political affiliation, and policy-making. The gap between official statistics and lived experiences highlights an ongoing challenge: bridging economic realities with public understanding. As we navigate future economic uncertainties, the interplay between inflation, policy, and democratic principles will continue to influence the health of our nation's economy and the strength of its democratic institutions. In the end, inflation is not just an economic indicator — it's the heartbeat of our democratic economic system.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.