The Federal Reserve and the Inflation Tax

Article I, Section 7 of the Constitution states, “All Bills for raising Revenue shall originate in the House of Representatives.” In other words, the Framers wanted to make sure that, when taxes are imposed on the people, the legislation giving rise to those taxes springs from the people’s House, the body closest to the nation’s citizens. No doubt the Framers thought that the taxing power of the federal government should not be taken lightly or at a distance from the people.

Just last Monday, speaking in New York to the Council on Foreign Relations, Federal Reserve Board Vice Chairman Stanley Fischer reiterated the Fed’s long-standing position that monetary policy should achieve an annual rate of price inflation of two percent. This targeted inflation is specifically in consumer prices. As anyone with common sense understands, such deliberate price inflation amounts to a tax on income earners, savers, and holders of cash assets -- essentially all Americans. Moreover, this two percent tax falls on top of all other properly enacted taxes. The consequences are severe. An annual two percent inflation rate means that the purchasing power of a dollar will decline by almost a third over 20 years. As far as I know, no citizen voted for this tax, nor endorsed a member of the House of Representatives campaigning on such a tax.

Under what authority does the Fed have this power to tax? Ostensibly it derives from the so-called “dual mandate” that Congress assigned to the Fed in 1977 when it passed the Humphrey-Hawkins Act. At that time, Congress told the Fed that its job is to promote maximum employment and stable prices. To most people, stable prices means, well, stable prices, i.e., no price inflation. Torturing the English language, however, the Fed defines stable prices to mean its targeted two percent inflation rate. The Fed holds that maintaining this rate satisfies the price stability prong of its dual mandate. 

The economic theory justifying this inflation tax is grounded in modern monetary thinking, which is a synthesis of traditional Keynesianism and Monetarism (hereinafter, “modern Keynesianism”). This theory holds that economic well-being and prosperity come about through spending. Therefore, spending, and especially consumer spending, must be encouraged. Indeed, saving is anathema to the theory.

One sure way to encourage spending is to punish financial prudence and frugality on the part of individual households. A positive inflation rate continuously maintained by design achieves this objective. People are incentivized to forego saving and spend now before the value of their income and cash assets decline even further.

A second way to encourage spending is to incentivize debt-taking. Continuous inflation, especially accompanied by artificially low interest rates, achieves this objective too. Debt-takers obtain relatively high value money to spend in the current period, and pay it back with relatively devalued money in a later period.

Another factor in this modern thinking is the idea that prices adjust faster than wages. Although a few prices may be fixed for a period by contract, most prices, especially consumer prices, can change quickly, if not immediately. By contrast, wages, more often fixed by contract, are usually slower to adjust to inflationary pressure. Even when not fixed by contract, burdens on both employees and employers can be severe with frequent turnover. Thus, even when higher wages might be had elsewhere, small gains in income may not be worth the burden of changing jobs.

Given this price/wage adjustment disparity, household incomes do not keep pace with price inflation, which creates still another incentive to accelerate spending. In addition, business earnings increase because revenues are rising faster than costs (i.e., prices are going up, while wages remain sticky). Hence, stock values inflate. This asset inflation, according to the modern thinking, produces a wealth effect that also encourages spending. That is, stockholders see their investments rise in nominal value, feel richer, and spend more. In addition, the sticky nominal wages mean that real wages decline over time, thus creating more demand for labor by businesses. Taken together, all of these behaviors -- households spending now rather than later, asset holders feeling wealthier and spending more, and businesses increasing demand for labor -- bring about prosperity in the form of higher nominal GDP and full employment.  

So goes the modern Keynesian story. The core premises of the story survive despite the historically slow recovery of the economy in the aftermath of the 2008 financial crisis. In fact, even allowing for fiscal policy failures, the evidence since 2008 is that monetary policy has done little to benefit middle and lower-income Americans by comparison to wealthier Americans with significant holdings of financial assets. Still, the Fed persists in its desire to tax Americans by boosting inflation through artificially low interest rates and perhaps even another round of quantitative easing. 

Nonetheless, there are several grounds on which to question the soundness of the Fed’s inflation tax. First, even taking the Fed’s monetary theory as valid notwithstanding its failures, no prominent economist of which I am aware has explained why two percent is the appropriate inflation rate to target. Why not three percent? Or one percent? In fact, there is nothing in the analytics of the theory itself that determines this precise rate. At a minimum, if the people are to be taxed an extra two percent a year, there should be a firmer foundation for that tax than simply the guesswork of unelected central bankers.

Second, the theory’s focus on consumer spending neglects capital accumulation. Capital accumulation is essential to economic growth. It is the basis for productivity gains in the economy. Capital accumulation, however, requires saving to finance the new capital. By making saving unattractive by means of the inflation tax, the rate of capital accumulation will be lower than what it otherwise would be. Although the inflation policy may give the illusion of stimulating economic activity in the short term, the longer-term consequences of diminished growth prospects are a lasting social cost.

Third, according to the Bureau of Labor Statistics, in the 100 years since the Fed’s founding, the price level in the U.S. has increased by over 2300%. This means that the value of the dollar has dropped by over 95%. This record is hardly one to be proud of. More significantly, it shows just how severe an inflation tax is over time.

Fourth, aside from economic and theoretical defects, an inflation tax that punishes prudence and thrift creates a culture that discourages personal responsibility. This result comes about in two ways. First, prudent saving for a rainy day or for retirement requires a willingness to see those savings depleted in real terms every year. Certainly at the margin, fewer people will choose to save, or save as much, with this looming prospect. Second, the inflation tax encourages debt-taking. Debtors are rewarded by inflation by being able to pay back loans with cheaper money. As a cultural phenomenon, widespread debt-taking leads to irresponsible spending, especially as it relates to short term spending by “maxing” out one’s credit cards, which often have among the highest interest rates. With thrift and saving being irrational, instant gratification becomes the norm.

Where does this leave us? Regrettably, a court is unlikely to find the Fed’s desired tax on the American people to be unconstitutional, as it does not derive directly from a “Revenue Bill” within the meaning of Article I, Section 7. Therefore, removing this taxing power will require legislation, a doubtful prospect. Even so, in this political season, it might not be too much to ask that the presidential candidates weigh in on the topic. Monetary policy being arcane to most in the media, however, I am not optimistic that the people will get answers. 

Mr. Gebhard is a lawyer and economist residing in Arlington, Va.

Article I, Section 7 of the Constitution states, “All Bills for raising Revenue shall originate in the House of Representatives.” In other words, the Framers wanted to make sure that, when taxes are imposed on the people, the legislation giving rise to those taxes springs from the people’s House, the body closest to the nation’s citizens. No doubt the Framers thought that the taxing power of the federal government should not be taken lightly or at a distance from the people.

Just last Monday, speaking in New York to the Council on Foreign Relations, Federal Reserve Board Vice Chairman Stanley Fischer reiterated the Fed’s long-standing position that monetary policy should achieve an annual rate of price inflation of two percent. This targeted inflation is specifically in consumer prices. As anyone with common sense understands, such deliberate price inflation amounts to a tax on income earners, savers, and holders of cash assets -- essentially all Americans. Moreover, this two percent tax falls on top of all other properly enacted taxes. The consequences are severe. An annual two percent inflation rate means that the purchasing power of a dollar will decline by almost a third over 20 years. As far as I know, no citizen voted for this tax, nor endorsed a member of the House of Representatives campaigning on such a tax.

Under what authority does the Fed have this power to tax? Ostensibly it derives from the so-called “dual mandate” that Congress assigned to the Fed in 1977 when it passed the Humphrey-Hawkins Act. At that time, Congress told the Fed that its job is to promote maximum employment and stable prices. To most people, stable prices means, well, stable prices, i.e., no price inflation. Torturing the English language, however, the Fed defines stable prices to mean its targeted two percent inflation rate. The Fed holds that maintaining this rate satisfies the price stability prong of its dual mandate. 

The economic theory justifying this inflation tax is grounded in modern monetary thinking, which is a synthesis of traditional Keynesianism and Monetarism (hereinafter, “modern Keynesianism”). This theory holds that economic well-being and prosperity come about through spending. Therefore, spending, and especially consumer spending, must be encouraged. Indeed, saving is anathema to the theory.

One sure way to encourage spending is to punish financial prudence and frugality on the part of individual households. A positive inflation rate continuously maintained by design achieves this objective. People are incentivized to forego saving and spend now before the value of their income and cash assets decline even further.

A second way to encourage spending is to incentivize debt-taking. Continuous inflation, especially accompanied by artificially low interest rates, achieves this objective too. Debt-takers obtain relatively high value money to spend in the current period, and pay it back with relatively devalued money in a later period.

Another factor in this modern thinking is the idea that prices adjust faster than wages. Although a few prices may be fixed for a period by contract, most prices, especially consumer prices, can change quickly, if not immediately. By contrast, wages, more often fixed by contract, are usually slower to adjust to inflationary pressure. Even when not fixed by contract, burdens on both employees and employers can be severe with frequent turnover. Thus, even when higher wages might be had elsewhere, small gains in income may not be worth the burden of changing jobs.

Given this price/wage adjustment disparity, household incomes do not keep pace with price inflation, which creates still another incentive to accelerate spending. In addition, business earnings increase because revenues are rising faster than costs (i.e., prices are going up, while wages remain sticky). Hence, stock values inflate. This asset inflation, according to the modern thinking, produces a wealth effect that also encourages spending. That is, stockholders see their investments rise in nominal value, feel richer, and spend more. In addition, the sticky nominal wages mean that real wages decline over time, thus creating more demand for labor by businesses. Taken together, all of these behaviors -- households spending now rather than later, asset holders feeling wealthier and spending more, and businesses increasing demand for labor -- bring about prosperity in the form of higher nominal GDP and full employment.  

So goes the modern Keynesian story. The core premises of the story survive despite the historically slow recovery of the economy in the aftermath of the 2008 financial crisis. In fact, even allowing for fiscal policy failures, the evidence since 2008 is that monetary policy has done little to benefit middle and lower-income Americans by comparison to wealthier Americans with significant holdings of financial assets. Still, the Fed persists in its desire to tax Americans by boosting inflation through artificially low interest rates and perhaps even another round of quantitative easing. 

Nonetheless, there are several grounds on which to question the soundness of the Fed’s inflation tax. First, even taking the Fed’s monetary theory as valid notwithstanding its failures, no prominent economist of which I am aware has explained why two percent is the appropriate inflation rate to target. Why not three percent? Or one percent? In fact, there is nothing in the analytics of the theory itself that determines this precise rate. At a minimum, if the people are to be taxed an extra two percent a year, there should be a firmer foundation for that tax than simply the guesswork of unelected central bankers.

Second, the theory’s focus on consumer spending neglects capital accumulation. Capital accumulation is essential to economic growth. It is the basis for productivity gains in the economy. Capital accumulation, however, requires saving to finance the new capital. By making saving unattractive by means of the inflation tax, the rate of capital accumulation will be lower than what it otherwise would be. Although the inflation policy may give the illusion of stimulating economic activity in the short term, the longer-term consequences of diminished growth prospects are a lasting social cost.

Third, according to the Bureau of Labor Statistics, in the 100 years since the Fed’s founding, the price level in the U.S. has increased by over 2300%. This means that the value of the dollar has dropped by over 95%. This record is hardly one to be proud of. More significantly, it shows just how severe an inflation tax is over time.

Fourth, aside from economic and theoretical defects, an inflation tax that punishes prudence and thrift creates a culture that discourages personal responsibility. This result comes about in two ways. First, prudent saving for a rainy day or for retirement requires a willingness to see those savings depleted in real terms every year. Certainly at the margin, fewer people will choose to save, or save as much, with this looming prospect. Second, the inflation tax encourages debt-taking. Debtors are rewarded by inflation by being able to pay back loans with cheaper money. As a cultural phenomenon, widespread debt-taking leads to irresponsible spending, especially as it relates to short term spending by “maxing” out one’s credit cards, which often have among the highest interest rates. With thrift and saving being irrational, instant gratification becomes the norm.

Where does this leave us? Regrettably, a court is unlikely to find the Fed’s desired tax on the American people to be unconstitutional, as it does not derive directly from a “Revenue Bill” within the meaning of Article I, Section 7. Therefore, removing this taxing power will require legislation, a doubtful prospect. Even so, in this political season, it might not be too much to ask that the presidential candidates weigh in on the topic. Monetary policy being arcane to most in the media, however, I am not optimistic that the people will get answers. 

Mr. Gebhard is a lawyer and economist residing in Arlington, Va.