The Federal Reserve (Fed) sets interest rates largely based on two metrics: observed inflation rate and unemployment rate. The basic idea behind the Fed’s actions is encapsulated in the Phillips curve (shown below) [1]. This model assumes an inverse monotonic relationship between inflation and unemployment: if inflation rises then unemployment decreases, and vice versa.

There are two significant problems with this model. Firstly, it doesn’t always apply. Milton Friedman won the Nobel prize in economics for identifying the phenomenon of stagflation: simultaneous increasing inflation and increasing unemployment. The second, much more significant problem with the Phillips curve are the definitions of inflation and unemployment.

Unemployment does not include those people who are retired or those that have not looked for work in over 4 weeks [1.1]. If employment were easier to attain (and, correspondingly, employees were paid more), people may choose to look harder and work longer. However, if it is difficult to find employment, people may give up looking. This difficulty is especially tough for those who are older [2]; many choose to retire early. When unemployment is high, many people choose to stay home and work as homemakers rather than seek employment. None of these groups are considered in the unemployment metric.

Regarding inflation, take a moment to realize how little information is encapsulated into the number that we call “the inflation rate”. Inflation is meant to quantify a change in prices across the entire economy. Consider the amount of information (in bits) required to store all prices of all goods; and then realize that all of that information is compressed into two significant digits (about 10 bits), which we call the inflation rate. Necessarily, a great deal of the information is lost. Let’s consider the type of information that gets lost. When pricing a computer, whatever a computer was in 1970 has little in relationship to the product that we call a computer today. Whatever a phone was in 1950 has little to do with what a phone is today. Even things that don’t change materially may use significantly different methods of production. Whereas milk was once produced by hand (by milking a cow), it is now done automatically with cows on conveyor belts [3]. This added automation makes the production of milk much less labor intensive, and so milk should be cheaper. For the Consumer Price Index (a government metric measuring inflation), prices are only considered for urban dwellers (the prices for people in rural areas are not taken into). Only a small subset of products are considered; notably, the price of real estate (and homes) is not included [4]. Finally, the products that get considered regularly change [5].

There is a category of product which doesn’t change materially and technology has not altered its ability to produce dramatically: precious metals. (Mining of precious metals has become less laborious but more capital intensive with time. And there have been additional uses found for these metals; e.g. dentistry and electric circuits. Notably, these effects act against each other. I will ignore these effects during this discussion but may revisit them in a later post.) Therefore, we can use the price of precious minerals as an accurate rate of inflation (though, this metric is not as related to the quality of life). The chart below shows how the price of gold has changed over the years [6].

There are two dates that are very relevant. Firstly, in 1913, the gold standard was changed. Prior to 1913, an individual could exchange dollars for gold (an ounce of gold cost $18.60); after 1913, only banks could exchange dollars gold (at the same rate). At this time, the U.S. government also revalued gold to $35 an ounce. The other date is 1971, when the US ended the gold standard entirely [6.1]. Note that the number of dollars required to purchase gold after this latter date has increased exponentially.

This increase in price can be seen as a consequence of the law of supply and demand. One can think of the price of a dollar as the amount of gold that it costs to purchase one. The more dollars, the less gold that a dollar costs (in accordance with the law of supply). The chart below shows the number of dollars in circulation versus the amount of gold owned by the U.S. Federal government. The price of gold is highly correlated with the ratio of dollars in existence to gold owned.

If we estimate the average inflation rate as constant (with the black line in the figure below), then we see that the value of gold has gone from $35 to $1300 since 1971. In gold, then, our dollars retain only 4% of their value when the dollar was still on some sort of gold standard. This is equivalent to an annual inflation rate of 7.5%. In this way, inflation acts like a tax; our dollars in our bank accounts are losing 7.5% of their value every year. Economists describe this inflation rate as “the hidden tax” since it is hidden to the consumer and it isn’t set directly by politicians [8].

In “How Much Do We Pay in Taxes“, I show that the income of a typical individual (living in Los Angeles) is taxed greater than 50%, but that did not account for inflation. With inflation, the dollars of an individual are taxed an additional 7.5% per year (for a total of 57.5%). However, unlike income taxes, this inflation tax is applied to an individual’s savings as well as their income. Note that sales tax, unlike income tax, is applied to the purchase price of a good. Therefore, the cost of sales tax increases with inflation. So, the higher a purchase price, the more revenue generated by sales tax. In this way, too, sales tax is much higher than the stated value.

The black line that I used to quantify past inflation is an extremely conservative estimate when considering future inflation rates. Production of dollars and the price of gold are both growing exponentially. It seems, then, that we will be experiencing much higher rates of inflation in the future. (If this prediction is accurate, it’s only accurate in the long term; I have no idea what is going to happen in the near future. In particular, I’m not sure why gold hasn’t lost more of its value in recent years, more closely following an exponential curve. I suspect that that massive deficit spending of the Federal government is putting off the pain associated with our current levels of printing of dollars. If you have any thoughts, especially if you disagree, I’d love to hear them.)

Current FDIC insured savings accounts are only paying 2% interest. Interest on BBB- rated bonds are currently 5%. When the 7.5% inflation is taken into account, one is losing between 2.5% to 5.5% on the principal of these investments. If the exponential curve comes to fruition, the loss on savings will be much greater.

[1] https://www.economicshelp.org/blog/1364/economics/phillips-curve-explained/

[1.1] https://www.bls.gov/cps/cps_htgm.pdf

[2] https://www.theladders.com/career-advice/new-study-proves-it-is-harder-to-find-a-job-as-you-get-older

[3] https://www.youtube.com/watch?v=kE2nFTZ5DIE

[4] https://www.cnbc.com/id/43769766

[5] https://www.theguardian.com/news/datablog/2012/mar/13/inflation-basket-goods-2012-full-list

[6] https://www.macrotrends.net/1333/historical-gold-prices-100-year-chart

[6.1] https://en.wikipedia.org/wiki/Nixon_shock

[7] https://www.gold-eagle.com/article/us-currency-circulation-us-gold-reserves

[8] https://www.theepochtimes.com/inflation-the-hidden-tax-2_2351198.html