In 1979, Paul Volcker became the chair of the U.S. Federal Reserve. With inflation running at about 13% a year, Chairman Volcker decided to stop the insanity. He slowed the growth of the money supply, and by 1983 inflation was down to 4%. Time magazines cover from October 22, 1979, pictured Volcker under the heading The Squeeze of 1979. This squeeze cranked up interest rates so that some rates exceeded 20%. Imagine getting a car loan or a mortgage in such an environment, and it is easy to see how tight money slowed the economy and reduced inflation.

Its Good to Be the King

In The History of the World, Part I, Mel Brooks remarks, Its good to be the king! The king has unique powers to achieve his goals (either nefarious as in the movie, or noble). Similarly, the Federal Reserve has unique rights that allow it to control the money supply, and through the money supply, to control inflation.

The injection of money into an economy can have a powerful effect. A simple personal example came when I was living in western Uganda in the summer of 1997. I was spending some time at a chimpanzee research station run by Harvard professor Richard Wrangham. Things were going fine, but I decided that I couldnt rely upon the stations truck for transport, and that I needed to buy my own vehicle.

Accordingly, I had my parents wire funds to a local bank so that I could purchase a motorcycle. With the help (and protection) of several of the research stations employees, I negotiated the purchase of a used motorcycle at the exorbitant price of $2,400.

As I rode the motorcycle along the local roads, people would greet me and then laugh to each other. They found the situation funny for many reasons. First, I was ridiculously large for the small motorcycle. Second, I had paid at least $1,000 more than a local would have paid (in Swahili, they said that I paid the Mzungu, or European, price). Third, there were

stickers on either side of the bike that showed a hunter with a spear. I was unaware that the spear was metaphorical, and that these stickers were public service messages to exhort the people to use condoms. So I became a mobile source of humor.

The actual purchase took place as follows. After reaching a deal on price, I went to the bank, took out the $2,400 in local currency. I was acutely aware that this represented close to a decades wages for the locals. I had guards on either side as I took my backpack full of bills and picked up my condom-advertisement machine. The previous owner asked me to hurry so that he could return the funds to the bank before closing time. In fact, he then returned the bills to the exact same bank manager who had given them to me earlier in the afternoon.

As I lay under my mosquito netting that night, I marveled at the power of electronic entries in the banking system. My parents sent an electronic message to a bank in western Uganda. Less than 24 hours later, I had a motorcycle and the electronic bookkeeping showed that the motorcycles previous owner had credit for $2,400. So by just moving a few electrons, I now controlled a motorcycle.

My motorcycle purchase created a whole cascade of effects. The previous owner was now rich with the proceeds of his sale. He used the money to buy a variety of products. The sellers of those products in turn purchased more goods. By injecting some money into the economy of western Uganda, I created a mini wave of prosperity. In my case, Ugandas prosperity came at the expense of some in the United States. While I was $2,400 richer, my parents were $2,400 poorer. This was a zero-sum game where gains were offset by losses.

Being the king of the monetary world, however, the Federal Reserve plays by its own rules. For me to get money, my parents had to lose money. When the U.S. Federal Reserve buys something, no ones account is reduced. The Fed controls the electronic system of bank credits. Thus, the Fed can increase an account by $2,400 or $240 billion with no offsetting reductions. While the Federal Reserve uses its power to buy U.S. Treasury bonds, and not motorcycles, the effect is the same as my mini wave of prosperity.

Except, the Federal Reserve can create money from nothing. It simply pays for its purchases by crediting the sellers account. While private transfers are zero-sum activities, the purchases of the Federal Reserve are not.

Through these monetary operations, the Federal Reserve determines the growth rate of the money supply, though the decisions of other people impact the effect of monetary operations. For example, the speed at which people spend their new riches has implications for the economy. Even after taking account of the velocity of money, the Federal Reserve controls the money supply and thus determines the rate of inflation.

Reading the Body Language of the Federal Reserve

In Rounders Matt Damon plays a reformed poker shark forced back into gambling by circumstances. Damons poker prowess lies in his ability to read other players and thus know what cards they have. Most professionals agree that the ability to size up opponents is a crucial skill needed to win at competitive poker. In these games, knowledge of human nature, not of the mathematical odds, provides the key advantage.

Predicting inflation also requires understanding the human actors controlling the situation. The rate of inflation is determined by the growth of the money supply. In the United States, the Federal Reserve controls the money supply. To make predictions about U.S. inflation, therefore, one must have a good idea of the future actions of the Federal Reserve.

Many people are willing to make bold predictions of future inflation rates. On one hand, you find books about how to protect yourself in the coming deflation. On the other hand, some foresee an inflationary world where investors must buy gold to protect themselves.

I remain unconvinced by those who make clear predictions about a future inflation or deflation. U.S inflation rates will be determined by the future decisions made by the Federal Reserve. A prediction of inflation