The Fed Is Confused About What Drives Inflation

On October 4 2017, the former governor of the Federal Reserve Daniel Tarullo in a speech at the Brookings think-tank in Washington said Fed policy makers do not have a reliable theory of what drives inflation. According to Tarullo, central bankers should pay less attention to theoretical models and more to actual data. However, how is it possible to make any sense of the data without having a reliable theory?

The Importance of Theory

One purpose of a theory is to enable one to ascertain the definition of a phenomenon that is subject to investigation.The correct definition attempts to identify the essence of the phenomenon (i.e., the key parts that drives the phenomenon). For instance, the definition of human action is not that people are engaged in all sorts of activities, but that they are engaged in purposeful activities – it is purpose that gives rise to an action.

So when Tarullo states that Fed policymakers do not know the causes that drive inflation he basically says that Fed policymakers have not as yet established the correct definition of inflation.

Is it then valid to be practical, as suggested by Tarullo, to focus only on the data to understand what inflation is all about? If Fed policymakers respond to changes in price indices without establishing what drives these changes this runs the risk of making things much worse.

Attempting to Define what Inflation Is All about

The subject matter of inflation is embezzlement by means of diluting the purchasing power of individuals. The source for this act of embezzlement is increases in money supply out of “thin air.” The increase in money out of “thin air” sets in motion an exchange of nothing for something or the diversion of real wealth from wealth generators to the holders of the newly created money.

As a rule, the diversion of real wealth by means of increases in money out of “thin air” tends to be manifested by general increases in prices. However, if the rate of increase in money supply corresponds to the growth rate of goods and services then no general increase in prices will emerge.