Welcome everyone to the 78th edition of Bogleheads on Investing. Today our special guest is Perilla Binder, a professor of economics at the University of Texas and an inflation historian. Today we're going to be discussing the history of inflation in the United States and her new book "Shock Values, Prices and Inflation in American Democracy." Hi everyone, my name is Rick Ferry and I am the host of Bogleheads on Investing.

This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a non-profit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net where you will find a treasure trove of information including transcripts of these podcasts.

I have a couple of announcements before we get started today. The YouTube videos from the 2024 Bogleheads Conference in Minneapolis, Minnesota are now available online at boglecenter.net. All of the sessions were recorded and they're all available for free at the Bogle Center website. Second, the 2025 conference will be in San Antonio, Texas the weekend of October 17th through the 19th.

It's in a wonderful location and it's going to be a fabulous conference. I'll provide more information on future podcasts when it becomes available. Our guest today is Carola Binder. She is an associate professor of economics at the University of Texas. She's a research associate for the National Bureau of Economics Research and she is also a fellow at the Hutchins Center on Fiscal and Monetary Policy.

She has a PhD from the University of California at Berkeley and her focus is on inflation, inflation expectations, monetary policy, and economic history. Carola Binder is the author of a new book and her first book on the history of inflation and price stability in the United States titled "Shock Values, Prices and Inflation in American Democracy." So with no further ado, let me introduce Carola Binder.

Welcome to the Bogleheads on Investing podcast, Carola. Thanks a lot for having me. I'm excited to be here. I was really interested in reading your book after seeing a review on a topic that I wanted to understand more about, which is price stability. Price stability is both inflation, deflation, disinflation, and all the things our government does to try to control prices.

Your book title is "Shock Values, Prices and Inflation in American Democracy." We'll get into the book in a few minutes, but before we do that, tell me a little bit about yourself, your background, why study economics, why concentrate on inflation. Sure. I'd be happy to. So I grew up in Louisville, Kentucky, and then I went to Georgia Tech for undergrad where I studied math, but I got more interested in the public policy side.

And so I decided to do a PhD in economics at Berkeley during the slow recovery period from the Great Recession where monetary policy was very interesting. The Fed was experimenting with new kinds of tools. I got interested at that point in studying inflation and studying inflation expectations as well.

Also, while I was at Berkeley, I met my husband and we've since had five children, so I'm a mom of five. Wow. Yeah. You're a busy person. I am busy. I started my career at Haverford College in Philadelphia. I worked there for nine years, and just this summer I moved to the University of Texas at Austin, partly to help with the start of a new school there called the School of Civic Leadership.

I'm building this whole new school, starting majors in civics honors and minors in civics and in politics, philosophy, and economics. In my first semester here at UT, I actually taught a course about my book, so it was called Inflation in America, and in the spring I'll be teaching a new course on democracy and capitalism.

That's a little bit about me. That's great. Your book, Shock Values, is to provide an account of how price fluctuations, inflation and deflation in government, attempts to manage these price fluctuations through things like paper money, price controls, tariffs, regulation, monetary policy, and other means. Inflation is not a 21st century or a 20th century phenomenon.

It goes back hundreds of years and different ways of trying to control it, which we'll get into. But before we get into the book, I do want to go over some of these terms, some of them which we already threw out to make sure that everybody's on the same page.

Let's start out with the basic one. Give me your definition of inflation. Inflation is growth in aggregate prices, so it's when prices in the economy are rising. Not just relative prices, so it's not just egg prices are rising or gas prices are rising. You have to have some measure of the aggregate or overall price level, and inflation would be the rate of change in that price level.

Then there's deflation. So what is deflation? Well, it's just the opposite of inflation. It's when aggregate prices are falling. Is deflation bad? It can be, and often it has been. It was very bad during the Great Depression when deflation is caused by too low of aggregate demand. But it doesn't necessarily need to be bad.

For example, you could imagine that there's a major boost in productivity. Everyone in the economy gets more productive. We can produce more stuff. That would tend to make prices fall. It could be even deflationary, but we would all feel richer. The kinds of deflation that we've more often experienced are deflation like in the Great Depression when prices are falling because nobody has that demand to buy stuff.

So that kind of deflation tends to be bad, and that's what the Federal Reserve really wants to try to avoid. Can wages deflate? Can Social Security deflate? Can people get less money in Social Security? Wages can fall, but employers know that people get really upset if their wages fall even if prices are falling, and that's actually one reason why deflation can be bad.

Think about when we had 8% inflation. Some people still got 2% wage increases. That's like the same as if they're being cut by 6% in real terms. But people didn't get too mad about that versus if we had had 0% inflation and your wages got cut by 6%. People would be more mad about that if they have some sort of nominal illusion.

And there's a name for that, correct? It's called the money illusion? Money illusion or nominal illusion. Economists more often call it nominal illusion these days, but money illusion also. And is this, do you think, one of the reasons why the Federal Reserve is targeting 2% inflation rather than 0%?

Yes, that's definitely one of the reasons because they want to give that little bit of buffer so that we don't get stuck in a world where there's -1% inflation and employers need to cut wages, but they can't do it because of the money illusion, so they would have to resort instead maybe to laying people off.

Interesting. Another term, disinflation. Yeah, disinflation. That means slowing down in the rate of inflation. So it sounds like deflation, but it's a little different. When inflation was at its peak of 9% or so, the Fed helped bring inflation down to 2 or 3%. We still have positive inflation. Prices are still increasing, but they're increasing at a slower rate and that's called disinflation.

Is there a reciprocal to that when inflation is increasing at a faster rate than it was? That exists. I don't think we have a name for it, just accelerating inflation or inflation is rising. I don't know why we have a special term for when it's falling, but not when it's rising.

Let's talk about demand and supply. This is one of the most basic economic theories having to do with pricing. Sure. It's actually a little bit hard to define demand without using the word demand in the definition, but demand or aggregate demand is what people want, all the goods and services that people want to buy.

And need to buy in some cases, like shelter, food, pharmaceuticals, things like this. Yeah. So it would be an aggregate demand includes consumption, investment, government spending, and net exports, which is exports minus imports. So basically the GDP equation. Yeah, it is the GDP equation, but what those all end up being depends on equilibrium with supply.

So demand is like at a given price, how much are people willing to buy? And then supply is how much would people be willing to produce at that price? But supply is more about the production side. Supply shocks are things like oil shocks, where there's a change in oil prices and that makes it more expensive to produce things.

So at any given market price, producers would be supplying less. And the name of your book is called Shock Value. So we're specifically talking about supply shocks that can occur from weather disasters, wars, and demand shocks, which are more, what do people want and what do they need and how much do they want and how much do they need at any given times?

And I'm assuming that's where your shock value came from. Yeah, it's a little bit of a play on words and my editor really wanted me to have a catchy title other than just my more technical subtitle. But yeah, it's a play on supply shocks and demand shocks and then also values as kind of a synonym for prices.

And your theory in the book is that it's these shocks that occur that cause government to act. Now, when there's a demand shock or there's a supply shock or both in the case of, say, the pandemic, it causes government to take action. And what action are they taking? And that's a lot of what your book is about.

Yeah. Although oftentimes the government itself is the source of the shock, this is not being political, it's just saying demand shocks, they often come because of monetary policy or because of fiscal policies. Fiscal spending is a positive demand shock or a central bank increasing the money supply is a positive demand shock.

The government maybe tightening certain kinds of regulations could be a negative supply shock. So a lot of the kind of downside of using the term shock is that it makes it sound like things just kind of randomly happen, but things do happen for reasons, and often the reason is policy.

I want to talk about the first price index. It was created, according to your book, by an Italian named Count Gianvinaldo Carli. Did I say that right? As far as I know. Yeah. Okay. So this was created in 1750. He was a mathematician and scientist and amongst other things.

And he wanted to kind of, I think, find out if it was true whether prices in Italy, which were going up at the time, were a result of something having to do with the price of gold or something having to do with what was going on with government debasement.

What does debasement mean? When you have gold or silver coins as money, debasement is shaving those coins down so there's less money for each unit. So if we had coins and we called them gold dollars and each one was worth one dollar, but the government shaved them down so instead of being one ounce each, they were three quarters of an ounce each, that would be debasing the currency.

The coins that he was thinking about were denominated in Italian lira. And what he found by estimating his price index, he was able to help show that prices were rising because the government was expanding the supply of lira denominated coins, but it wasn't actually expanding the supply of gold itself.

So this was increasing prices in terms of lira. You know, I've read that and I said, this is the 1750s. And even though that price index was created for him to investigate why prices of goods in Italy were rising, people knew that the government was doing this. Sometimes the government tries to hide things, like different ways of debasing their currencies.

And people know this. Maybe they have scales or maybe they knew that it wasn't 100% gold in the gold coin. Maybe it was only 90% gold and 10% lead or something. But as people began to realize this, they began to not accept these coins or at least accept them at a lower value, thus inflation.

You can't get away with this stuff for very long. Yeah, you're right, expectations and beliefs play a big role in inflation. So when people start to realize that these coins are worth less in terms of gold or in terms of silver, then they're going to say, well, I need more of them in order to exchange something with you, and that's why prices rise.

Price indexes started in this country, when? When did we have our first price index here in the US? First official ones, at least, I think were in the 1880s or 1890s. The Bureau of Labor was producing these kinds of indexes. They got a group of researchers to go and collect data on thousands of different prices.

They were able to collect price data back to about 1860 and construct these indexes. There were more informally constructed price indexes even before that. I think even during the Civil War, there was some interest in knowing how the greenbacks were affecting prices. So people would construct price indexes of their own, maybe using a smaller number of prices in the basket, but 1890s was the first official one.

From there, we have moved on to more modern indices. What is the CPI? The CPI stands for the Consumer Price Index, and that is the most commonly used, most widely reported price index in the US today. What the CPI tries to do is capture how prices are rising for a typical consumer, a typical urban consumer in the US.

To construct the index, the Bureau of Labor Statistics needs to do some surveys to figure out what people actually spend their money on so that they're able to say, okay, maybe 5% of spending is on gasoline and X% is on egg and on socks and things like that. Then they also have to measure the prices of all these things.

They have a somewhat complicated formula, but they weight all the different price changes by their consumption weights so that they're able to say, okay, if you're a typical household in the US in a city, how much is the price of your whole consumption basket increasing? Why did they create a core CPI rather than just the standard CPI that includes everything?

Yeah, that standard one we call the headline CPI. The core strips out the prices of food and energy, which are the most volatile prices, so they tend to have big fluctuations both up and down. Constructing the core is helpful in seeing maybe a clearer signal of underlying trends. It just strips away a lot of the noise.

That sense it's useful for policy makers like at the Federal Reserve who want to respond to where they think inflation is heading, not overreact to inflation that's increasing just because of energy prices. How does the CPI differ from the PCE, which is the Fed's personal consumption expenditure, which is the one we hear about in the background, not the headline?

The PCE, personal consumption expenditures price index, that's the probably next most important one in the United States. That's the one that the Federal Reserve targets when they say they have a 2% inflation target. They really mean they want PCE inflation to be around 2%. It differs from the CPI because differences in the formula, some differences in the weights that different categories get, and even some difference in exactly whether you include just consumption by consumers for themselves or you also include things like employer-sponsored health insurance.

There's different categories of spending that are included in the two indexes. As a result, the PCE tends to be about half a percentage point lower than the CPI on average. When the Fed is targeting 2% PCE inflation, it's like they're targeting 2.5% CPI inflation. I didn't know that about the half a percent difference.

That difference can change over time because the two indexes, for example, weight housing very differently. If you have major change in house prices, you might get a bigger than usual gap between PCE and CPI. It's not always half a percent, but that's what it tends to be around. What is it that the government used to increase Social Security benefits?

Which one of those two? They used CPI. Most of the government uses the CPI as their main inflation measure. The Fed is a little unique in using the PCE. There's a lot of debate at the Fed when they first started inflation targeting about which measure they should use, and there was some argument for we should do the same as the rest of the US government is doing, but they ultimately felt that the PCE was a better measure of inflation and decided to go with that one.

If you want to cut the budget deficit by reducing increases in government wages and Social Security, that the federal government would go to the Fed's model, which is a half a percent less than the CPI. Yeah. I don't actually get into this in the book, but in an article I recently wrote for Works in Progress magazine, it's about these different measures of inflation and some of the politics behind them.

There have been various commissions over the years to study the CPI and how it's measured, in part because there was concern that the CPI was overstating inflation and an eagerness to say, "Well, let's figure out why it's overstating inflation and get a more accurate measure," and that's also going to have this benefit of reducing the government's budget deficit because our expenditures on things like Social Security will be lower.

You can probably guess what interest groups were opposed to those kinds of changes. Last one is the producer price index, PPI. What is it and why is it important? The producer price index, it's similar to the consumer price index, but it's trying to measure the prices that producers are going to face rather than consumers.

It's more of a measure from a seller's perspective rather than a consumer's perspective. We're going to run into some more terms as we start going through your book, but I wanted to just get those basic ones out before we jump into shock values, prices and inflation in American democracy.

There's a soap act with stuff. Each one of these chapters itself could be a book. You went through the entire history of the United States, even prehistory when we were still under British rule. Quite fascinating to read. One thing you said, though, I understood it because I was in the military for, well, I actually did more than 21 years, total active duty and reserve time.

We have a saying in the military that the plans that you make are always fighting the last war. When we went into Desert Storm, we were wearing green camis in the desert. We were planning for the jungle because that's what the Vietnam War was. Anyway, you said the same thing about fighting inflation.

You said the government's decisions on these brushes of price instability have not created a more perfect union, but one that reflects its most recent failures, in other words, fighting the last war. I find that was an interesting quote. Oh, thank you. And thank you for your service. The clearest example I think I can give is the recent one, which is when the Fed adopted average inflation targeting just a couple of years ago during the pandemic.

For many years, the Fed had been struggling with inflation that was actually lower than their 2% target. They felt that high inflation was a thing of the past, but they were really concerned that they couldn't keep inflation high enough. So they decided to change the way they did inflation targeting and say, "We're going to have it be asymmetric.

So if we undershoot our 2% target, we promise we'll make up for it by overshooting, but not vice versa." So this asymmetry was designed to help them boost inflation back up. When they were coming up with that, I don't think they had in mind something like we actually saw happen, which was inflation getting out of control again, inflation getting really high again.

And of course, that is what happened. So they were fighting that last battle, fighting the battle of, you know, the 2010s was basically a battle of inflation is too low. What can we do to boost it? They forgot about the other battle, which is when inflation gets too high.

Let's talk about the four themes that you have in the book, and then we're going to get into each of these chapters. The first one is price fluctuations affect different interest groups in different ways. And classic in your book is what hurts the farmers helps manufacturing. Right. So one of the big implications of inflation is what it does to debt, because debt tends to be in nominal terms.

The reason that deflation hurt farmers and inflation helped them is because they tended to be debtors. They would take out nominal debts in order to buy their seeds and equipment to be able to grow their crops. When you have a nominal debt, if there's inflation, that erodes away some of the value of that debt and helps you out, and vice versa if there's deflation.

We don't have really a society of farmers anymore, but we still have some people who are debtors, some people who are creditors, and inflation is going to affect them differently. It also affects people in different ways because of the kinds of assets that they own and also because of different kinds of jobs.

Your wages might be more or less likely to keep up with inflation. You might be more or less susceptible to losing your job if there's a monetary tightening. People buy different stuff also. When there's inflation, not all prices are rising at the same rate. So some people will feel it a lot more.

That's why inflation tends to cause a lot of political tensions because it's affecting different people in different ways, and they have different preferences about what the policy response should be. We don't have the agrarian economy we used to have, but we do have a lot of homeowners, people who take out 30-year mortgages at sometimes very low interest rates.

And then we have renters, people who don't own a home, they rent. And of course, high inflation hurts renters, helps people who have a home because it causes the value of the home to go up, and they rent at a low interest rate. So there are winners and losers.

And so it makes it tough when you're doing policy, whatever you do is going to hurt one group and help another. The second part of the theme was inflation has a different effect on debtors as it does on creditors, which we just talked about. And the third theme that you have was something that I learned back in the 1990s when I was getting my master's in finance, and it was, and I'm going to say this wrong, but crisis and Leviathanian?

I think it might be Leviathan, but I don't actually know either. That's how it's spelled. It was the title of a book in 1987 by Robert Higgs, and it was about how whenever there's a national emergency, the federal government gets more authority over economic decision making. And then that doesn't totally go away when the crisis is over.

So it has this kind of ratchet effect that gives the government authority that's just widening over time. There was a famous quote by Rahm Emanuel, a politician from Chicago, and President Obama's former chief of staff who famously said, "You never want a serious crisis to go to waste." And finally, the long road to inflation targeting.

This is the fourth theme. This theme is about the power of ideas and the idea that we have now of having an independent central bank with some numerical target that is delegated responsibility for price stabilization, something that the U.S. only adopted fairly late. We only officially got an inflation target in 2012, but it was an idea that was brewing for quite a long time.

So a lot of the book tells the story, especially of some of the key people behind that idea. So those are the four themes of the book. Price fluctuations affect different interest groups. Inflation has different effects on debtors and creditors. The government has a more active role when there is a price shock, which never completely goes away.

And finally, trying to get it right, you know, through maybe inflation targeting of some sort and coming up with what is a better metric than maybe what we currently are using. So now we can get into the book, the 14 chapters that you have, which I do want to start out with inflation during colonial times.

So here we are, not even a nation under British rule, what was going on and what are the major highlights? So one highlight there is the power of having control over monetary arrangements. That was something that the colonies at first didn't have. Great Britain had different policies to limit the colonists' ability to issue money or have any sort of paper currency.

Then it came time for the Revolutionary War. You have wartime inflation because, you know, they finally just started printing more money. And then the post-war deflation. During that Revolutionary War inflation, there was some push for price controls. Some were actually implemented, but only at very local levels because there wasn't really any federal authority to try to impose price controls at broad scale.

So they weren't very effective, but also there was just a lot of philosophical opposition to price controls because they were seen as illegitimate. It was seen as like forcing people to sell stuff against their consent, which the founders were very uncomfortable with. When there was deflation after the war, that led to Shays' Rebellion, which was basically a big uprising led by farmers and veterans who were so hurt by the deflation and left a big impression on the founders saying how bad these price fluctuations can be for social stability.

And that led to Washington appointing Jefferson, the first Secretary of State, and Hamilton, the first Treasury Secretary, and under Hamilton, Congress created the first bank of the United States to try to help control some of these fluctuations. This is about the years between the Constitutional Convention up until the election of President Jackson.

There were two different national banks that were started in those years, the first bank of the United States and the second bank of the United States. They're in some ways precursors to the Federal Reserve. They did some of the things that the Fed later did, although they weren't exactly a central bank.

But there was a lot of tension between Jefferson and Madison and those that were more supportive of farmers and thinking of the U.S. as a nation that should be an agrarian nation versus Hamilton and those that wanted to develop finance and manufacturing. All the conflicts around these banks, why their charters eventually were not renewed.

Leading ahead here to the War of 1812, here is where we saw our first national distribution of paper money, which became inflationary. And then following the war, many changes took place that became known as the American system. Yeah. So after the War of 1812, this American system, that's a name from Senator Henry Clay of Kentucky.

The system included the Tariff Act of 1816. The Tariff Act came because farmers actually fared pretty well after the war. There was increased European demand for U.S. crops. There was a natural disaster, actually a volcanic eruption that led to crop failures in some parts of the world, which meant higher prices for the crops that American farmers were producing.

But the domestic manufacturers in the U.S. were not faring very well because they were getting these lower priced British manufactured goods. So inexpensive imports were coming in from Europe. That was hurting the domestic manufacturers in the U.S. who were mostly in the north. They went to Congress demanding a tariff as protection against these low prices that they were facing from abroad.

So that tariff was the first pillar of the American system. During the War of 1812, there was no national bank. The First Bank of the United States had lost its charter right before the war. So the second pillar was a new national bank. Just to clarify, these banks, they were only given a charter for so many years, and then it ended.

Right. They were given a 20-year charter, and at the end of the 20-year charter, it would go up for renewal. And in both cases, the banks didn't get their charter renewed. Now, the Federal Reserve, when it was started, also was given a 20-year charter, but eventually before that charter was up, there was a vote to extend its charter into perpetuity.

And a third leg of this was this new second national bank would be a mechanism for expanding the country's infrastructure, roads, canals, and so forth. Right. Fairly strong bank president came along for the second national bank, Nicholas Biddle, and he created a lot of policies and really pushed forward the idea of a federal or national bank and how it's going to work.

And that caused a lot of growth here in the United States. Nicholas Biddle, when he was the leader of the second bank, he was trying to kind of help the U.S. have more of a uniform currency and regulate those state banks. They were sort of hard to get under control.

They had the tendency to overissue their bank notes. What's probably most famous about Biddle is his kind of antagonistic relationship with President Andrew Jackson, who Jackson really distrusted banks in general. He distrusted the second bank because he thought, you know, it gave too much power to a few private citizens and it didn't really have oversight from Congress or the president.

So he was campaigning against the second bank. He vetoed a bill that would have extended its charter. He stopped depositing the government's funds in the bank and put them instead into like his, what were called his pet banks, state banks that he preferred. And eventually the second bank also lost its charter just the way the first bank had.

When the Civil War came along, the North and the South both issued their own paper currencies to finance the war. The North financed the Civil War with greenbacks and the South financed their war with graybacks. What was the difference between the greenbacks and the graybacks? Because the graybacks got inflated away very quickly and the greenbacks did not.

Yeah. There are some interesting economic history papers trying to study the hyperinflation of the graybacks. And again, part of the story is expectations. So people have done really fascinating studies where they look at what happens to greenback prices and grayback prices when particular battles are won. So when people get a better idea, uncertainty goes down a little bit about who's going to win the war.

That affects the prices because it depends on who wins the war, how much the greenbacks or the graybacks are going to be worth in the future. So I think once people started to realize that the South was going to lose and they knew that graybacks would be worthless, that means that there's like a hyperinflation in terms of grayback prices.

The Confederacy can't really get anyone to accept them. They have to print more and more to try to buy anything with them. Now, when the war was over, Grant became president. He wanted to revert back to the gold standard. But it was a group called the Grangers and they had a three-part proposal that focused on monetary policy, regulatory policy, and fiscal policy.

And when reading the book, it seemed like this was really an important part of our history, the Grangers. Yeah. This was a movement of farmers. Remember what I said about farmers being hurt by deflation because of their debts? So during the Civil War, you know, as you can imagine with the greenbacks being issued with this like big paper money expansion, there was inflation.

Then, as you said, after the war, there was this desire to gradually return to gold. So like contracting the greenbacks out of the money supply. That led to deflation, which really, really hurt the farmers. So there was this movement called the National Grange. There was basically three different ways that they thought that we could counteract the deflation.

One would be with more expansionary monetary policy, which would either mean keeping the greenbacks or at least using silver and gold rather than just gold. You could also have regulatory policies to help the farmer, like price controls on the railroads that farmers relied on to transport their crops. And you could also have tariffs.

And this was also the era that the first independent regulatory authority, the ICC, was created. What did the ICC do? ICC, the Interstate Commerce Commission, they were basically doing a form of price controls. They required railroads to charge rates that were called reasonable and just. So it was left a little vague, but basically railroads weren't allowed to charge higher rates on longer haul trips than shorter hauls.

It was supposed to help the farmers because they accused the railroads of price gouging them because they needed the railroads in order to be able to sell their crops. But, you know, as you can imagine, it was pretty controversial. And there was a lot of questions about, you know, even constitutional questions about whether these kinds of price controls were constitutional or not.

So we went through a period after the Civil War that was a lot of financial panics. We had the financial panic of 1873, the financial panic of 1893, the financial panic of 1907. And finally, the Aldrich-Verlin Act of 1908, which says, hey, we need to do something here. We need to create something that looks like Federal Reserve Bank.

And that led to the Jekyll Island Accord. Talk a little bit about what happened at Jekyll Island. Yes. So Nelson Aldrich, that's what the Aldrich-Verlin Act, that's where the name Aldrich is from. Nelson Aldrich led the National Monetary Commission. It was prompted by the panic of 1907, which was such a major financial panic that there was recognition that we need some sort of institution to help deal with this.

And Nelson Aldrich led the commission in investigating monetary and banking systems of a lot of different European countries. You can actually go read the reports of the commission today, they're all online. They looked at how different countries in Europe had different sorts of central banks, more or less centralized central banks, and the role of their central banks in acting as a lender of last resort to the financial system.

They studied the discount system that was used by central banks in Germany and France and England and how those contributed to financial stability. So then Aldrich came up with a plan for the U.S. based on those studies. The plan would have established a really centralized system. He called it the National Reserve Association.

He met up with other bankers and people from the financial system in secret on Jekyll Island to discuss the plans for the system, but their plans aren't what eventually became the Federal Reserve Act. So there's a lot of changes to the plan because, as you can imagine, Congress wasn't all happy with having this highly centralized system that seemed like it was designed by bankers to help bankers.

So there was a lot of compromises and that's why we have the Federal Reserve System we have today, which is like a weird mix of centralized and not centralized with the different regional reserve banks, but also the Federal Reserve Board in D.C. The first test of this central bank that ended up being formed was World War I and post World War I.

During World War I, inflation rose substantially the year before by like 46% in this country between 1916 and 1917. We entered the war in 1917 and then a lot of price fixing took place, which caused inflation to only rise by 17% from 1917 to 1918. But everybody thought that, okay, the war's over and now prices are going to fall back and we're going to have a deflation and it's going to be very painful.

But what happened was the central bank, the Fed, sort of flooded the economy with money and we did not have a massive deflation that we had seen after other wars. And so people came to realize that monetary policy may even work. Yeah. Well, first that really big 46% price increase that you mentioned from 1916 to 1917, that was really because of food prices.

So as fighting was happening in Europe, there wasn't much food production over there. So there was such a strong demand for American crops and that's why you had prices rising so quickly. And Woodrow Wilson was president and he really had this idea of government as administrators and he thought, we need technocrats here to help handle this problem and set up a system of price controls.

It wasn't a complete system of price control, so not all prices were controlled, but some were. It was certainly more than was able to be done during the Revolutionary War because now we had a relatively strong federal government to be able to administer them. The important thing to remember is when the Fed was created, that didn't do away with the gold standard.

The U.S. was still on the gold standard. A lot of the rest of the world was too, but they mostly left the gold standard in order to fight the war and then were trying to return to the gold standard after the war. But it was really hard for countries to return to the gold standard after they had inflated their currencies so much during the war.

So after World War I, there was kind of a new gold standard put into place called the gold exchange standard and it didn't work exactly like the pre-World War I gold standard and for many reasons didn't work as well. During this period of time, interest rates were controlled not by the banks, correct?

Actually it was the Treasury. So the Fed, the discount rate was the interest rate that they would use as like their policy rate, but the Treasury required them to keep interest rates low in order to keep the Treasury's expenditures down. And then afterwards, when they were allowed to finally raise rates because inflation did start coming back.

Yeah, they waited a while to raise rates after the war. It's not like today where the Fed had inflation as its target, so they weren't like, "Oh, inflation is rising, so we need to raise rates." They were trying to maintain the gold standard. So when interest rates are low, that's going to tend to make gold flow out of the country because investors are going to want to send their funds somewhere where they can get a higher rate of return.

When the U.S. was holding interest rates low because of that Treasury peg, eventually they were losing gold. And that's why some people at the Fed wanted to raise rates, others didn't, and there was some tension between the Fed and the Treasury over when and whether they could raise rates.

So they wait a while to raise rates, and when they do, they increase them pretty quickly. A major increase in the discount rate kicked off a recession of 1920 and 1921, which was very deflationary, so prices were falling, which had the same exact problems for the farmers as that post-Civil War deflation did.

Basically what happened that led to the Great Depression and falling prices, starting in 1929? Yeah. In some ways it was a parallel to the 1920-1921 recession. The Fed raised discount rates. It's hard to get into all the details in a short amount of time, but because the world was on the gold standard, but central banks were also concerned about domestic conditions and not strictly about the gold standard, there was a lot of trouble when the Fed raised interest rates.

Countries were scrambling to try to maintain their gold, but also maintain domestic employment, and the whole system kind of got caught up. Farm prices, especially in the U.S., were falling. There was major deflation of all prices, but especially farm prices. So farmers felt particularly hurt by the deflation. And since it was worldwide, it meant our trade partners were in depression as well, which then meant that there were less people for us to sell to.

So prices were falling, and unemployment was very, very high, and central banks seemed at a loss for what to do, especially while they were trying to maintain the gold standard. So Roosevelt comes along in 1933 with the New Deal. Roosevelt at first wants to reverse deflation and get back to zero inflation or no inflation.

He puts on price and wage controls, comes up with this idea of a living wage. The stock market did bottom in 1932, but the recessions did continue through 1937. A lot of that was blamed on labor, Fair Labor Act standards, first minimum wage, and so forth. When Roosevelt took office, he kind of said, "We need to somehow check this decline in prices, even if that means inflating the currency," and there was legislation passed that gave the executive more authority over monetary policy.

He eventually took the U.S. off the gold standard, which meant that then it was possible to do monetary expansion, that deflation was reversed, and a lot of the rest of the world also went off of the gold standard. He also passed a lot of other New Deal policies that people might be familiar with.

There was a lot of court scrutiny over different policies that Roosevelt passed, particularly considering how they interfered with freedom of contracting, and the court had a turn of opinion that basically enabled the New Deal policies to be upheld. Roosevelt's policies do get inflation down, but it's a very slow recovery.

World War II comes along, and we saw the same cycle that occurs in wars. There were spikes in commodity prices, there were shortages, there was price controls, there was even an office of price control, wage controls, and so forth. And then when the war was over, a lot of the controls come off, and prices skyrocket.

In fact, by 1947, inflation was 17%. Now we had too much inflation again. Yes. And Truman came back in with wage and price controls during the Korean War, if I'm correct, and got inflation down a little bit. Yes. We get through the 1950s into the 1960s, John Kennedy becomes president.

He advocates for more government expansion into social programs, begins talking about a national healthcare system that was to eventually become Medicare and Medicaid under Johnson, and then Johnson labels it the Great Society, and creates another piece of landmark legislation. He also at the same time wanted to fund the Vietnam War, so lots of government expenses.

Johnson wanted to keep interest rates low during this period of time in order for all this stuff to work. And you wrote in your book, "These were the seeds of inflation." Yeah. He met with the Federal Reserve Chair, Chairman Martin, at the time. Martin was the Federal Reserve Chair for much of the 1950s and the 1960s, and I'd say in the 1950s he did a relatively good job keeping inflation fairly low and stable.

Johnson called Martin to a meeting at his ranch and tried to convince him that for easier monetary policy, Martin resisted that pressure from President Johnson, but at the same time that's when the Fed did start letting the money supply grow more quickly. Milton Friedman at the time warned that the money supply was expanding too rapidly and that it was going to be inflationary, eventually led to the Great Inflation of the 1970s.

Nixon comes in. Nixon had been a lawyer at the Office of Price Administration during World War II, so he was familiar with price controls, didn't really like price controls, but didn't like high inflation either. That's right. He did enact price controls in a three-phase program, but when he removed price controls in the third phase in 1973, it caused inflation to absolutely skyrocket.

Yeah, he was really resistant to controls at first because of his experience during World War II. He thought of price controls as requiring a lot of government snooping, these slide rule boys and snoopsters are kind of snooping around in your business because price controls does require a lot of government surveillance in all aspects of business, but the Fed Chairman Arthur Burns eventually convinced him that he needed to start, they called it incomes policy at the time, meaning price and wage controls because Chairman Burns didn't think that the Fed was actually capable of controlling inflation and thought that it had to be done by these kinds of controls, which in the first phase were pretty popular and seemed to be working, but it was sort of just holding back the floodgates, and as soon as they were loosened, all that inflation came right back.

This caused the Arab oil embargo here in the United States, which caused more inflation and created what's called stagflation, where inflation is rising, but the economy is stagnant. Right. It was a tough period. I was a teenager during this period of time in college. Yeah. Stagflation is the combination of high inflation with high unemployment, so that's different than what we had in 2022.

We had high inflation, but at least the unemployment rate was low, so we were in that way much better off than the U.S. was during the stagflationary 1970s. It was funny during this period of time that the Fed didn't believe that they could control this. When Ford comes in after Nixon and he starts his Whip Inflation Now program, I remember the wind buttons.

It didn't really work. Right. Took the Fed chairman, Paul Volcker's disinflation, to convince people that that monetary policy could control inflation. Before that, Arthur Burns thought that, well, that the inflation was driven by supply shocks, that the Fed couldn't do anything about it, that it wouldn't be just too costly for anyone to bear, and the Volcker disinflation was costly.

There was a big recession and unemployment, but eventually it took getting inflation down and building the Fed's credibility so that then unemployment could also come down. That all happened during the Reagan era. Prior to that, Carter era, I remember Carter's malaise speech. He wasn't willing either to monetize inflation away by raising interest rates when Volcker came in.

Volcker was Fed chairman, but he still couldn't enact what I think he wanted to enact, which was to let interest rates rise as high as they needed to. Reagan did allow Volcker to do that. He also went on this idea of union busting and knocking down union who was demanding higher and higher wages.

Very, very high interest rates in the early '80s did break the back of inflation finally. The Fed is vindicated in a way with Volcker showing that monetary policy is a way to control inflation and then bring in Greenspan. Greenspan kind of had it easy, I always thought. I mean, we had a good period of time.

Inflation was falling. It was a pretty good period for the Fed. So under Greenspan, in some ways, the Fed was doing inflation targeting, but not explicitly. Greenspan really didn't want to say that the Fed had a 2% target or had a 3% target, but the Fed was able to keep prices relatively stable, largely because of Greenspan's own credibility.

A lot of people trusted him. It kept expectations relatively stable, and he was able to lead the Fed through the Great Moderation era, the time after that Great Inflation, but before the Great Recession. And even as other central banks around the world, it started in like the '90s to adopt inflation targeting, Greenspan didn't.

It was the successor, Ben Bernanke, who was really a big proponent of inflation targeting and eventually got the Fed to adopt it. Bernanke comes in, in 2006, and then the Great Recession happens, mortgage market falls apart due to what has been blamed as a lack of regulatory control over the writing of subprime mortgages.

That caused Bernanke to do some really unusual things to keep the country from entering a depression. So we had a recession, but not a depression because of lots of things the Fed was now able to do. He got more control. Yeah, Bernanke was a scholar of the Great Depression, and I think that his background in economic history really convinced him that the Fed could avoid the kind of Great Depression that had happened, and he was determined not to let the Great Recession be like the Great Depression.

He wanted to use unconventional monetary policy to keep major deflation from happening. So there was a tiny bit of deflation at the start of the Great Recession, but nothing like what we had in the Great Depression. So things stabilize, and we get to the pandemic, and here, in my view, and again, it's just my opinion, it's almost overdoing everything to try to ensure that people had money coming in and interest rates going, in some places around the world, to negative by central banks.

We didn't get there. I think there was one day T-bills actually went negative. Do you think it was an overdoing of fiscal policy and monetary policy, which then ended up causing the inflation that we've recently seen? Yeah, I think the Fed learned from the Great Recession, they responded too slowly and not strongly enough, and so there was this low aggregate demand that lasted for a really long time.

The recovery from the Great Recession was so slow. Inflation stayed below target for so long. We were at the zero lower bound for so long. The unemployment rate took so long to return to normal that they wanted to err on the side of over-responding in 2020 and 2021. I mentioned they changed their monetary policy framework to average inflation targeting, which basically, the change in the framework, the way it was worded, gave them some leeway to wait a little longer to raise rates when inflation started rising than they probably would have under their previous framework.

And on top of that, excessive fiscal stimulus in the form of not one check, not two checks, but three checks. This caused lots of money in the money supply, and at the same time, we had a decrease in demand because a lot of people were staying at home. It was just all an explosion in potential inflation, which then got us to where we are today, which is the Fed had to significantly and quickly raise interest rates in order to rein in inflation.

Yeah, initial decrease in demand from people staying home, that would tend to reduce inflation or even be deflationary, but there was also this reduction in supply when people aren't getting work done or when there's geopolitical shocks, etc., supply chain issues. What we had was a big increase in demand because of the combination of all the stimulus checks, which are positive aggregate demand shocks, and also the monetary policy was also boosting aggregate demand.

So those are what were inflationary. So here we are today, 2025, and the Fed is lowering rates because inflation is getting closer to their target. You personally are not a big fan of using inflation only as the target for the Fed. You believe in nominal GDP as a better target than just inflation.

So I'm going to give you the stage here for the last couple of minutes and just tell me why. Yeah, well, so the Fed, they do have an inflation target, but they don't have just an inflation target. They have a dual mandate. So they have to balance these two different goals, which is price stability, but also full employment, and those can come into tension.

So sometimes to maintain price stability, we need to raise interest rates, but to maintain full employment, we need to cut them, and that then gives the Fed a lot of discretion because they could choose either one and they could justify cutting or raising. It also makes investors and consumers more uncertain about what the Fed might do because they don't know exactly what kind of rule the Fed is following and they don't know how much they're going to prioritize either side of their dual mandate.

So the reason I like nominal GDP targeting is because it gives the Fed a single target that if they pursue it, it should allow them to fulfill both sides of the dual mandate. The Fed can't choose to not have a dual mandate. Congress gave them a dual mandate, but they could say, "Well, the way we're going to do it is by stabilizing the path of nominal GDP," because nominal GDP growth is just the sum of real GDP growth and inflation.

So if you say, "Let's keep nominal GDP growing at 5% per year," for example, that would be consistent with real GDP growing at 3% a year and inflation at 2%. And sometimes the economy is hit by a supply shock and so we get higher inflation and lower real GDP growth or vice versa.

We sometimes get productivity shock and get higher real GDP growth and lower inflation. But either way, you just keep nominal income growing steadily. That actually helps a lot with the whole debtor versus creditor issue that we've talked about a couple of times because when people are thinking about taking out a nominal debt, what really matters is for their ability to pay it back is what is going to happen with their nominal income.

And you think 5% is the number? I use that more for illustrative purposes, not that I know what the exact number should be. You would want to figure out what do you think is potential real GDP growth. If you think it's 3% and you think that 2% inflation sounds good, then you would add those up and get 5, but it could be a little lower or higher.

I don't have a strong opinion about that. Are any countries doing this right now? No, they're not. So inflation targeting, I think partly it was just a path dependency thing where it was adopted first and it became the norm. I'm not a fan of inflation targeting. I think inflation targeting is much better than most alternatives.

But if you're going to make up for undershooting the target, then also make up for overshooting the target. Yeah, which isn't the case right now. Right. So they're a true average right now because they make up for undershooting the target, but not for overshooting the targets. It's a work in progress and maybe you could be one of the people on the forefront of what's going to happen next.

Oh, thank you. Carola, thank you so much for being our guest on Bogleheads on Investing. I learned so much today. Thanks so much for having me. This concludes this episode of Bogleheads on Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads Wiki, Bogleheads Twitter, the Bogleheads YouTube channel, Bogleheads Facebook, Bogleheads Reddit.

Join one of your local Bogleheads chapters and get others to join. Thanks for listening.