MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

YOU DECIDE: Will gas prices spark an inflation explosion?

By Dr. Mike Walden
North Carolina Cooperative Extension Service

Gasoline prices — need I remind you? — are up an amazing 53 percent in the last year. While many economists don't think that's enough to send the economy into a recession, they do think it will slow economic growth. This means fewer jobs will be created and family income won't rise as much.

Yet many worry that higher fuel prices may have another shoe to drop: higher general inflation. After all, gas is used either directly or indirectly in most things we buy. So it would make sense that the jump in gas prices will lead to a protracted jump in other prices.

Economists have a special term for slow economic growth and higher inflation: stagflation. It doesn't paint a pretty picture. Everything gets more expensive, but incomes don't keep up. The last time we had a bad stagflation bout was in the 1970s.

So are we headed to stagflation? It appears we have the slower economy. Isn't it almost assured we'll get the higher economy-wide inflation?

While the common answer is yes, another argument says no. To see why requires some background on money's role in the economy and the power of the Federal Reserve.

Extensive economic research over several decades reveals a simple fact. Inflation, or a continuous rise in prices, must be facilitated by a corresponding increase in the supply of money. For inflation to increase — meaning prices are rising at a faster rate – there must be “too much money chasing too few goods,” to quote an economists' cliche. In other words, the increase in money must exceed the increase in the things money is used to buy.

I can now hear you saying, “So what? Won't money spent in the economy increase when gas prices increase?” Not actually, and here's where the Federal Reserve comes in.

The Fed controls the country's money supply, increasing or decreasing bank lending through its influence. Usually the Fed increases the amount of money, but how fast it does so can vary. If the Fed ramps up the increase in the money supply with no change in the growth of goods and services, then the inflation rate rises.

So the Fed has in its control the ability to contain the jumps in energy prices and prevent them from spilling over into other prices. If the Fed keeps money growth at a moderate pace, additional spending on gas and energy products can only occur through reduced spending on other products, thereby reducing the non-energy inflation rate.

In the 1970s we experienced shortfalls in gas supplies, and gas prices skyrocketed. In a move that some interpreted as trying to fool consumers into thinking they could afford the higher energy prices, the Fed rapidly expanded the money supply. The result was stagflation. The economy-wide inflation rate hit double digits, and at the same time the economic engine stalled.

Today the Fed is taking a different tactic. The money supply is increasing at a rate between 4 percent and 5 percent per year.

This is consistent with a predicted annual inflation rate of 1 percent to 2 percent. And guess what? This is exactly what's happening! In the last year, despite the tremendous spikes in gas and other energy prices, prices outside the energy sector have increased only 1.5 percent.

Now don't get me wrong. I'm not implying that the increases in energy prices are costless. We will all pay for them by spending more on energy products and cutting back on the other things we normally buy.

Higher energy prices have sparked concern about a new explosion in all prices. It doesn't have to happen, and hasn't so far.

But this decision isn't in our hands. It's in the hands of those running the Federal Reserve.

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Dr. Mike Walden is a William Neal Reynolds Professor and extension
economist in the Department of Agricultural and Resource Economics of North
Carolina State University's College of Agriculture and Life Sciences. He
teaches and writes on personal finance, economic outlook and public policy.
His You Decide column is provided every two weeks by the Department of
Communication Services. Earlier You Decide columns are available on the Web
at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm
Related audio files are at
http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html