The Federal Reserve’s Misdiagnosis: Inflation Encompasses More Than Price Increases

The Misunderstood Nature of Inflation: A Deep Dive into Definition and Consequences

The annual Jackson Hole Economic Symposium serves as a platform for dissecting critical economic issues, with inflation consistently topping the agenda. However, the term “inflation” itself has become a source of confusion, its meaning morphing over time. While the traditional definition centers on an excessive increase in the money supply, the modern interpretation, particularly among central bankers, focuses narrowly on rising consumer prices. This shift has significant implications for how we understand and address the phenomenon.

The popular definition, adopted and refined by institutions like the Federal Reserve, equates inflation solely with increases in the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) index. This narrow focus excludes asset price increases, such as those in housing or stocks, creating a potentially misleading picture of the overall economic impact of monetary expansion. Defining inflation merely as a rise in consumer prices obscures the underlying causes and can lead to misdirected policy responses.

A more fundamental definition of inflation, as proposed by economist George Reisman, emphasizes the causative role of government intervention in the money supply. This perspective identifies inflation as “an increase in the quantity of money caused by the government,” which distinguishes it from price increases stemming from other factors like supply disruptions or shifts in consumer demand. This definition recognizes that, in a free market, natural forces constrain money creation, limiting the potential for excessive expansion.

The dangers of misdefining inflation become starkly apparent when examining historical examples like the Japanese asset bubble of the 1980s. This period witnessed a dramatic surge in Japanese stock and real estate prices, fueled by excessive money creation directed by the Bank of Japan (BOJ) under its “window guidance” lending system. While initially aimed at post-war economic recovery, this system evolved into a tool for manipulating asset prices. The BOJ, aiming to weaken the yen following the US abandonment of the gold standard, aggressively increased lending quotas, particularly in the real estate sector.

This flood of new money, channeled primarily into asset markets, resulted in a speculative frenzy. Property values skyrocketed, creating a sense of artificial prosperity, while the underlying productive capacity of the economy was not commensurately enhanced. The Cantillon Effect, which describes how new money impacts prices depending on where it is initially injected, played a significant role. As new money flowed predominantly into real estate and stocks, these asset classes experienced the most dramatic price increases, creating a bubble detached from real economic activity.

Confusing this asset inflation with genuine economic growth, observers lauded the “new Japanese economy,” attributing the apparent prosperity to increased productivity. However, this narrative overlooked the unsustainable nature of the boom, driven by excessive and misdirected credit creation. The bubble eventually burst in the late 1980s, when the BOJ abruptly reversed its policy, triggering a devastating collapse in asset prices. The ensuing economic stagnation, widespread bankruptcies, and social hardship underscored the dangers of manipulating the money supply and misallocating capital.

The Japanese experience highlights the crucial distinction between productive and unproductive money creation. Productive money creation, typically driven by private sector lending based on sound economic principles, supports real economic growth. Unproductive money creation, often orchestrated by government intervention, fuels speculative bubbles and distorts market signals, leading to malinvestment and ultimately, economic instability. The Japanese case demonstrated how government-directed credit can create a mirage of prosperity, masking underlying fragilities that eventually surface with devastating consequences.

The key takeaway from the Japanese asset bubble, and indeed from other historical examples, is that excessive money creation, particularly when directed by government policy, has far-reaching negative consequences that extend beyond rising consumer prices. These include distorted price signals, misallocation of capital, widening wealth inequality, and increased financial instability. By narrowly defining inflation as merely a rise in consumer prices, we risk overlooking these broader systemic risks. A more comprehensive understanding of inflation, rooted in its fundamental cause – government-induced monetary expansion – is essential for developing sound economic policies and preventing future crises. Furthermore, understanding the Cantillon Effect is crucial for anticipating how new money will impact specific sectors of the economy depending on where it is initially injected.

The ultimate lesson from the Japanese experience, echoing Hazlitt’s warning, is that inflation, in its true sense of excessive money creation, undermines economic stability, fuels speculation, and erodes economic morality. It is a dangerous path that ultimately leads to “bitter disillusion and collapse.” Recognizing the true nature of inflation and its multifaceted consequences is paramount for promoting sustainable economic growth and safeguarding financial stability.