The MOTHER of all MYTHS

OVER and OVER the mainstream media mindlessly propagates the myth that the Fed 'fights' inflation by increasing INTEREST rates. It's time to put this colossal fiction to rest, once and for all.

Let's start by defining inflation:

[a] persistent increase in the level of consumer prices OR a persistent decline in the purchasing power of money

But, are they both the same thing? And what triggers them?

Demand-Pull Inflation - [is] summarized as "too much money chasing too few goods." In other words, if demand is growing faster than supply, then prices will increase. This usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase prices to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports. [of course, no one ever mentions interest]

This raises some KEY questions. First, does each type of inflation require a different monetary approach in response?

And if so, how does the Fed know which type of inflation the economy is suffering from?

To answer the second, there's no indication that the Fed distinguishes between the two causes of inflation. In fact, it appears that regardless of its cause, the Fed has a 'one size fits all' method of dealing with inflation that comes in two favorite flavors: open market operations and the discount rate.

That makes the cause of inflation irrelevant, at least when it comes to the Fed's response. But, we shall see that, as the aggregate level of debt accumulates in the economy, the underlying cause of inflation becomes increasingly important with respect to the effect the Fed's response has on the economy.

Through open market operations, the Fed increases or decreases bank reserves by buying or selling securities, respectively. "The Fed buys securities when it wants to increase the flow of money and credit, and sells securities when it wants to reduce the flow."

When the Fed sees that too much money is going through the economy and prices are rising too quickly (inflation), they put the brakes on by selling securities. This reduces the amount of reserves available to banks, causing interest rates to rise, and banks will not make as many loans because it costs more for consumers to borrow.

Or, the Fed increases or decreases the infamous discount rate, thereby setting "the interest rate that a regional Reserve Bank charges banks and financial institutions when they borrow funds on a short-term basis."

Changes in the discount rate can affect:

• Lending rates (by making it either more or less expensive for banks to get money to lend or hold in reserve)

• Other open market interest rates in the economy (because of its "announcement effect") [NOTE: it need not actually affect prices, but only threaten to]

Let's ignore, for now, the glaring illegitimacy of a private banking cartel that allows member banks to create their own money from thin air and lend it out at interest!

By now, it should be fairly obvious that, by increasing the supply of money and credit beyond the level of productivity in the economy, the Fed (and its cohorts) cause demand-pull inflation.

(See, Why the Federal Reserve is Irrelevant for a compelling argument that banks wield unfettered control over the money supply through zero-reserve lending.)

In fact, the only other possible cause of demand-pull inflation is a decline in productivity, which the Fed (and its cohorts) bring about by contracting the money supply, making it more difficult to conduct business, i.e., be productive!

You see, even though increased dollars to goods ratio can cause the price of goods to rise, the inverse does not necessarily cause deflation - not for products whose marginal cost is relatively high, or whose price is inelastic.

In fact, in an economy like ours where control over capital and industry is concentrated in a handful of corporations, if push comes to shove, they are more likely to destroy or hoard their goods before selling them at below optimum price in our market.

So, when the Fed 'tightens' the money supply through open market operations it merely arrests the inflation that it caused!

BUT also, when the Fed 'tightens' the money supply, it slows down the economy (a.k.a. productivity) which in turn pulls on the dollars to goods ratio, keeping prices inflated!

But, hold on to your hats; it gets worse.

Next, we examine cost-push inflation and ask how does the Fed know when to act?

Basically, the Fed monitors consumer PRICES and the COSTS of doing business, focusing mainly on the cost of labor.

As I've already demonstrated, the inflated prices that you and I perpetually suffer from are different from the prices that the Fed relies upon to guide its monetary policy. While they worry about "core" inflation, we suffer from REAL inflation measured by an index of prices that include volatile goods (food and energy).

Why are they volatile? Because we need these products, so suppliers extort whatever price the market will bear.

Why does the Fed ignore volatile prices, and act only on changes in core, or elastic prices?

First, the Fed doesn't care about us. But also, there's NO risk that the price of necessary goods would deflate below desired price; every price is the desired price! Control over food and energy sectors is so concentrated that suppliers simply dictate prices, consumers either pay or do without the product.

Finally, the cost variable the Fed seems to monitor more closely than any other is Labor.

[L]abor accounts for roughly two-thirds of all business costs.

Is that really true? Not entirely.

The exact proportion varies according to the capital versus the labor, maintenance, administrative and other costs of the goods and services we buy. [see, Margrit Kennedy, PDF p.3]

For example, garbage collection is very labor intensive, whereas public housing is not. So, even though ours is primarily a service economy, it is also an economy saddled with DEBT, i.e., high financing costs, which may dramatically affect the ratio of capital to labor costs.

Nevertheless, the Fed focuses almost exclusively on labor. Consider the following formula used by a senior analyst to predict whether the Fed will tighten the money supply:

"This is a Fed tightening trifecta: strong economic growth (via payrolls), resource utilization pressures (via the unemployment rate) and inflation risks (via average weekly earnings)."

There are a number of things wrong with this formula. First, all these indicators are consistent with increased productivity. Companies certainly don't hire more people unless they're productive, and while lower unemployment and increased wages may indicate, as the Fed argues, a 'tightened labor market,' it's still not inconsistent with productivity; ordinarily, where profits are the goal, companies would never dish out what they could not recoup.

What business does the Fed have stifling productivity???

Moreover, this formula focuses only on labor, to the exclusion of other costs, specifically, capital.

Nevertheless, this economist sees the following labor figures as clear evidence that the Fed will increase rates yet again in March of this year:

• The unemployment rate in the [US] dipped to 4.7 per cent last month, its lowest level since July 2001.

• Employers added 193,000 new jobs in January for the biggest addition since November; and

• Average hourly earnings also edged up in January, climbing by 0.4 per cent – matching December's gain.

First, it is not clear that these estimates of fluctuations in labor (which are at best tenuous) can actually cause inflation. For example, a new technology or business process may improve productivity such that increases in labor costs would not (necessarily) increase the price of goods.

But also, the economy's aggregate financing costs may already be so high that any effort to 'fight' the higher cost of increased wages with a further increase in interest rates could have disastrous consequences, like stagflation:

"the combination of high unemployment and economic stagnation with inflation."

So, to sum it up, the Fed (and its cohorts) cause demand-pull inflation, after which they badly exacerbate cost-push inflation by raising interest rates in our already debt-ridden economy.

The TRUTH is that the Fed does NOT, and CANNOT 'fight' inflation by increasing interest rates.

If anything, the Fed fights de-flation and productivity, to the benefit of banks and their offspring corporations and to the detriment of American workers and consumers.