Advanced Personal Finance

How The Fed Generates Inflation

Regardless of how accurately you think the U.S. government reports on inflation (I think the reported rate of inflation is a lie and I hate the so-called ‘core’ CPI), everyone can agree on one thing - it’s there. Inflation is right behind death and taxes on the list of ‘things to count on.’

But how does it happen? I mean, why do things, overall, get more expensive? Why does a dollar buy less today than it did last year? The answer is - the federal government generated that inflation.

How the U.S. government creates inflation

The stated purpose of the Federal Reserve (’The Fed’) is to create price stability. Here it is directly from them:

The fundamental mission of the Federal Reserve System is to foster the stability, integrity and efficiency of the nation’s monetary, financial and payment systems in order to promote optimal macroeconomic performance.

The fundamental mission of the Federal Reserve System is to foster the stability, integrity and efficiency of the nation’s monetary, financial and payment systems in order to promote optimal macroeconomic performance.

So why am I saying the government is generating inflation? Here’s how it works.

The Fed buys Treasuries from banks in what’s known as a repo. Repo is short for repurchase agreement. A repo is like a collaterized loan, but ownership of the asset (Treasuries, in this case) actually changes hands. The Fed hands over cold cash to the bank at a very low interest rate.

The bank now has lots of cash to loan or invest. It keeps a little bit in the vaults by law (the ‘fractional reserve’) and loans the rest at a higher rate or invests it.

Voila. The Fed has just created money, albeit in a somewhat convoluted way. Technically, the term inflation refers to that increase in the money supply. You and I use it to mean the resulting increase in prices that always accompanies a growing supply of cash.

So through the use of repos, the federal government has just generated inflation. Thanks Fed!