Inflation, an increase in the general money price level (“nominal inflation”), causes substantial concern across households, boardrooms, legislative chambers, and central banks alike. It erodes the real value of fixed pensions and annuities and income from bonds. It increases income taxes. It distorts business and government decisions. However, since wages usually go up with inflation over time, the effect of inflation on wage earners is not as significant, right?
Not necessarily! It depends on whether the inflation is the typical inflation caused by loose monetary policy (“monetary inflation”) or “real inflation.” Real inflation is particularly insidious because wages do not go up with real inflation. So, not only is the value of retirement savings, bonds, and the like eroded, but the value of work itself is eroded! To compound the problem, if the Federal Reserve Board tries to fight real inflation with tight monetary policy, it will likely cause unemployment and recession.
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So, what is “real inflation” and what causes it? Real inflation is caused when the real costs, not just the nominal costs, of goods and services increase. Real inflation is usually “cost-push inflation” as in the two cases discussed below, but it can also be “demand-pull inflation.”
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Real inflation caused by real increases in the world price of oil
The United States is starting to experience some real inflation as a result of the increase in the price of oil due to the Iran war. The U.S. had very substantial real inflation in the 1970s when OPEC, the oil cartel, drastically increased the price of imported oil tenfold, from $3 to over $30 a barrel. Then, the U.S. had to pay more than 10 times as much in real goods — wheat, corn, cars, and computers — for the same amount of oil. This real inflation, like monetary inflation, caused nominal inflation of goods and services to increase, but it did not cause nominal wages to increase.
As a result, real inflation caused real wages, real gross domestic product, and real gross domestic income to decline while nominal inflation roared on. This result is called “stagflation,” which has been the normal consequence of substantial real inflation. However, substantial real inflation does not, by itself, cause unemployment or recession.
Unemployment and recession were caused when the Federal Reserve Board tried to fight this real inflation with tight monetary policy. Why? Since wages do not go up with real inflation, using monetary policy to fight real inflation means that nominal wages must decline. Workers strongly resist reductions to their nominal wages. Economists refer to this phenomenon as “sticky wages.” Some will quit their jobs rather than take a nominal pay cut because they believe that they can get another job at the same nominal wage as before. It will take time before they realize that they must accept a reduction in their nominal wages to get a job, so employment declines along with GDP for a while.
The current increases in the world price of oil is again causing real inflation, but the amount of this real inflation is a small fraction of that caused in the 1970s for three reasons: (1) the increase in the price of oil is small compared to the increases in the 1970s; (2) the increase is likely to be of a very short duration compared to the increases in the 1970s; (3) the U.S. is not very dependent on foreign oil for its energy needs as it was in the 1970s.
Real inflation caused by Trump’s tariffs
The U.S. is also experiencing real inflation from President Donald Trump’s tariffs. Virtually all economists recognize that free trade benefits all nations involved (even countries that are less efficient than others in producing all their goods and services, because of the Law of Comparative Advantage). Free trade causes the opposite of real inflation — it causes the average real costs of goods and services to decline for all countries participating in free trade. If free trade is reduced by tariffs, then the result is real inflation.
Since nominal inflation reflects the combined effects of real inflation and monetary inflation, nominal inflation can increase due to real inflation while unemployment is also increasing.
The Fed should change its inflation policy
To avoid causing stagflation, the Federal Reserve should adopt the following rule: The Fed should not use monetary policy to fight real inflation.
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This rule requires that the Fed separately estimate the amount of real inflation and monetary inflation in the economy — a task easier said than done. It also means that the Fed should not try to reduce the level of nominal inflation below the level of real inflation, even if real inflation is greater than its 2% target.
Davis D. Thompson practiced as a corporate and tax attorney for 30 years before becoming a registered investment adviser in 2019.
