Tag Archives: inflation

Inflation is a Monetary Phenomenon, But This Isn’t Inflation

There has been much talk recently about the potential inflation on the horizon given the unprecedented movement of the Federal Reserve of increasing the monetary base through quantitative easing. The talk has predominantly surrounded the substantial increase in the monetary base. However, increases in the monetary base are not sufficient to cause inflation. Like discussion of other markets, we must consider both supply and demand conditions.

Milton Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon.” Friedman was undoubtedly correct. However, recently a few seem to have taken this claim to mean something different entirely. Namely, that any increase in the money supply necessarily causes inflation. This is something that Friedman himself did not believe.

In his restatement of the quantity theory of money, Friedman pointed out that the quantity theory is primarily a theory of money demand. Specifically, quantity theorists view the level of real money balances as more important than the nominal quantity of money. Thus, if at any point in time people have chosen to hold some level of real money balances that they deem optimal, an increase in the nominal money supply will leave these individuals with a larger level of real money balances than they wish to hold. These individuals will then necessarily try to reduce their holdings of nominal money balances such that their real money balances fall back to their optimal level (perhaps by increasing spending). Unfortunately, as a group, they will not be able to do so because every person’s spending is another person’s receipt (or income). Initially output will increase and gradually prices will rise until the level of real balances falls back to the optimal level.

Given this discussion, it should not be difficult to understand why I prefer a monetary equilibrium framework. What’s more, it should be apparent that what causes inflation is not an increase in the money supply, but rather an excess supply of money.

Ultimately, the question at hand is whether the current increases in the monetary base imply that there is an excess supply for money. If so, inflation is on the horizon. If not, we need not fear inflation.

Personally, I do not believe that the recent increases in base money imply that there is an excess supply of money. There are a couple reasons for this belief. First, it has been well-known — at least among monetarists — since Clark Warburton’s influential work that the peaks in the time series variables important for quantity theorists follow this order: (1) money, (2) output, and (3) velocity. The implication here is that declines in velocity (increases in the demand for money) are an accentuating feature of the business cycle. In other words, after output begins to fall, the demand for money increases. As our previous discussion of monetary equilibrium implies, this creates an excess demand for money, which results in falling output and prices — thereby exacerbating the previous decline in output.

Second, the money multiplier has declined drastically. In fact, the money multiplier for M1 remains below 1. This means that for every increase of $1 in base money, the money supply (as measured by M1) increases by less than $1. In order to determine the cause of the decline in the M1 multiplier, we should first discuss its components. The money multiplier for M1 consists of the currency-to-deposit ratio, the required reserve-to-deposit ratio, and the excess reserve-to-deposit ratio. An increase in any of these ratios implies that the money multiplier will fall. The required reserve ratio is set by the Federal Reserve and has not changed. Thus, the decline in the M1 multiplier must be the result of changes in the currency-to-deposit ratio and the excess reserve ratio. As previously mentioned, the demand for money often increases during the downturn in the business cycle. What’s more, financial crises often induce a flight to quality in which individuals abandon risky investments for safe investments such as bonds or cash. The increase in cash balances increases the currency-to-deposit ratio.

The largest cause of the decline in the money multiplier, however, is the result of the increase in the level of excess reserves. What’s more, this increase in excess reserves can be directly attributed to the fact that the Federal Reserve started paying interest on excess reserves late last year. In doing so, the Fed essentially reduced the opportunity cost of holding excess reserves thereby giving banks the incentive to hold more reserves on their balance sheets. This is why our friend Scott Sumner not only supports eliminating the interest payments on excess reserves, but prefers that the Fed impose a penalty on those who hold reserves above the required level.

Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%. Given that we are currently in a recession, this suggests that the Fed wants to increase the money supply rather than simply maintain the earlier level. Given that the monetary base is about 90% higher than it was at this time last year, this would suggest that the Fed is expansionary, but hardly over-expansionary given the circumstances surrounding money demand.

With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. A failure to do so would result in a substantial period of inflation. However, at the current time, the evidence suggests that the massive increase in the monetary base is justified by the increase in the demand for base money. Thus, the increase is in the monetary base doesn’t suggest that massive inflation is on the horizon … yet.

(In the future, I hope to post on how the Fed can prevent finding itself in such a precarious situation in the future, but this is clearly enough for now.)

Zero Inflation?

Was 2008 really the year of zero inflation? Perhaps not. From the WSJ’s Real Time Economics:

Measured on a December to December – or calendar year – basis, the consumer price index only grew 0.1% in 2008, according to Labor Department figures, the smallest gain in over 50 years and well below the 4.1% gain in 2007.

But when the annual average of the CPI for all of 2008 is compared to the average for 2007, the increase was much higher, 3.8%. That was actually up from 2007’s rate.

“It’s unusual for there to be this big of a difference,” said Labor Department analyst Stephen Reed. The two series sometimes line up exactly, and usually when there’s a gap it’s only a few tenths of a percentage point.

I actually prefer the calendar year measure, but an anomaly nonetheless.

Inflation Inequality

The conventional wisdom is that inflation always hits the poor the hardest. Writing over at VoxEU, Christian Broda of the University of Chicago disagrees and suggests that the larger inflation burden falls on the richest households:

Inflation differentials between the rich and poor dramatically change our view of the evolution of inequality in America. Inflation of the richest 10 percent of American households has been 6 percentage points higher than that of the poorest 10 percent over the period 1994 – 2005. This means that real inequality in America, if you measure it correctly, has been roughly unchanged. And the reason is just as dramatic as the result. Why has inflation for the poor been lower than that for the rich? In large part it is because of China and Wal-Mart!

Here is a non-gated link to his recent research paper on the topic.

The Fed Meeting, Redux

Perhaps we should offer Ben Bernanke a do-over. On Wednesday the FOMC decided to hold interest rates steady despite the fact that global inflationary pressures are heating up. The statement released by the Fed hinted that they may raise rates in the future, but simultaneously talked of the weakening labor market and the perils of the credit markets. In doing so, the statement sent shivers down the spines of both those who are worried about inflation and those who are worried about rate hikes.

As an inflation hawk, I have been a bit careless with my recommendations to raise interest rates and I have not sufficiently answered those who are concerned with unemployment and the fragility of the economy. Thus, allow me to elaborate.

In a recent Bloomberg interview, Nobel laureate Ned Phelps wondered aloud whether or not the Fed understands anything about modern monetary policy. What Phelps was communicating is the fact that the Federal Reserve seems unable to distinguish between transitory changes in unemployment and those driven by structural changes in the economy. As Phelps rightly pointed out, the collapse of housing boom has created a restructuring within the economy. It is highly probable therefore that the natural rate of unemployment has risen. If so, any attempt by the Federal Reserve to combat rising unemployment with lower interest rates will prove to be futile. In light of such thinking, it is quite understandable that talk of rising unemployment in the FOMC statement was particularly troubling.

Worries about the credit markets are similarly overblown. So long as the Fed stands ready to serve as lender of last resort, a task they have admirably performed thus far, further crisis should remain averted even in the midst of higher interest rates.

Bernanke and the FOMC made a mistake by not raising interest rates on Wednesday (as indicated by the rising prices of gold, oil, and other commodities). The rise in unemployment is not temporary and therefore need not be of concern to the Fed. In the meantime, global inflation and inflationary expectations are on the rise. Let’s hope that the Fed doesn’t make the same mistake when August rolls around.

An Inflation Conspiracy?

Those of us who have been hawkish on inflation have been lonely for several months now. However, recent data has suggested that the Federal Reserve may soon start raising rates again. Nevertheless, there are a group of individuals who believe that the inflation numbers are actually worse. Our friend Barry Ritholtz has been leading the charge claiming that BLS data is understating inflation and unemployment (some have referred to these claims as conspiracy theories). I think that Barry is correct to assert that inflation is worse than the numbers indicate, however, I do not think that the numbers are the problem.

The real problem is that our focus is always on the overall price level rather than relative prices. Commodity prices are on the rise, and will continue to be, so long as the world remains awash in liquidity and real interest rates remain low. The former stokes the demand fire and the latter provides a disincentive for discovery and investment. Looking at the overall price level, it seems as though inflation is quite modest all things considered (albeit above most economists comfort level). The reason that inflation seems so much worse than the numbers indicate is because the prices of things that most consumers consider necessities, like gasoline and food, are experiencing the most rapid increases. In an economy where homeowners were (are?) more leveraged than they have ever been, they are now seeing their wealth decline due to falling home prices while simultaneously experiencing an increase in the costs of food and gasoline.

The world has largely been awash in liquidity for the better part of this decade. Despite this increase in liquidity, price indices have largely been held down by the rapid productivity growth beginning at the end of the 1990s and continuing through the first half of this decade. These low levels of inflation, however, were providing incorrect signals to central banks and fears of deflation reinforced the easy money policies. The proverbial chickens, however, are now coming home to roost. Productivity has begun to slow and can no longer be counted on to hold down prices.

What can the Fed do?

The best solution that the Fed can provide is to begin raising the Federal funds rate. Aggressively raising rates should start to reign in liquidity and lower inflation expectations. Higher real interest rates should provide the incentive for an increase in oil production and reigning in liquidity should reduce demand thereby putting downward pressure on oil prices and likely other commodities as well. Critics may charge that the economy cannot cope with higher interest rates. However, so long as the Fed stands ready to act as lender of last resort (a role they have performed well thus far), the U.S. economy should be able to weather the storm.

There may not be an inflation conspiracy, but inflation is a much bigger problem than the numbers indicate. It is time for the Fed to reverse course and start raising interest rates.

Inflation and Why this “Feels” Like a Recession

Paul Krugman writes:

But as I said, this time around there’s no wage-price spiral in sight.

The inflation hawks point out that consumers are, for the first time in decades, telling pollsters that they expect a sharp rise in prices over the next year. Fair enough.

But where are the unions demanding 11-percent-a-year wage increases? (Where are the unions, period?) Consumers are worried about inflation, but you have to search far and wide to find workers demanding compensation in the form of higher wages, let alone employers willing to accept those demands. In fact, wage growth actually seems to be slowing, thanks to the weakness of the job market.

And since there isn’t a wage-price spiral, we don’t need higher interest rates to get inflation under control. When the surge in commodity prices levels off — and it will; the laws of supply and demand haven’t been repealed — inflation will subside on its own.

Krugman is right in pointing out that wages are not beginning (or in the midst of) an inflationary spiral. Krugman seems to blame the invisible presence of the unions. Their invisibility could be due to their declining power and/or the fact that inflation today is quite different than the 1970s, but not for reasons that Krugman emphasizes. In my view, it is not the case that invisibility of the labor unions is the cause of a different kind of inflation, but rather that a different kind of inflation is causing the invisibility of the unions.

During the 1970s, the inflation rate was rising at a much higher rate than is currently the case. Energy prices were high, but there were also a great deal of other prices on the rise as well. As Krugman points out:

In May 1981, the United Mine Workers signed a contract with coal mine operators locking in wage increases averaging 11 percent a year over the next three years. The union demanded such a large pay hike because it expected the double-digit inflation of the late 1970s to continue; the mine owners thought they could afford to meet the union’s demands because they expected big future increases in coal prices, which had risen 40 percent over the previous three years.

Where the current situation is different is that the rise in the price level is less diversified. Food and energy prices are leading the charge, while technology and globalization are putting downward pressure on other prices. The result is that despite the fact that prices of consumer staples are rising, the overall inflation rate remains low by historical standards. This may also explain Krugman’s claim that, “it feels like a recession to most people” even if it technically isn’t. When the economy is slowing and the prices of consumer staples are rising, it forces some belt-tightening.

What to do about the current situation, however, is somewhat more difficult. Krugman believes that there is too much risk involved in raising rates and precipitating further crisis in the financial markets. However, one must also bear in mind that the low rate policies in the wake of September 11 and afterward largely set the stage for the current credit crisis. In my view, thanks in large part to financial market innovation, inflation targeting has proven to be quite inept. In addition, targeting a rate of inflation and simultaneously ignoring the forces of globalization and productivity growth leads to an environment of easy money. The economy is (and has been) moving ever toward completely inside money of the variety described by Wicksell, which makes monetary policy and especially inflation targeting more difficult to conduct.

In any event, I am convinced that the Fed Funds rate is below the natural rate and leaving it there for some time will only lead to further asset price bubbles. If there are underlying problems in the financial market, we cannot ignore them by keeping rates low and hoping that they will go away.

Keynes on Inflation

J.M. Keynes on inflation in The Economic Consequences of the Peace (p. 235-6):

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

HT: Robert Higgs

A Look At Inflation

Recall from the equation of exchange that:


where M is money, V is velocity, P is the price level, and Y is real output. Therefore, when written as growth rates (assuming velocity is constant):

Inflation = Money (M2) growth – Real GDP growth

Inflation is thus graphed below:


The graph begs the question, “where are the inflation hawks?”

Inflation Expectations

Inflation? What inflation?

Expectations are rising…

HT: Greg Mankiw

Inflation Hawks?

Andrew Samwick writes

Over the past few years, cheap credit and imprudent lending policies by some bad actors generated excessive consumption and investment in the real estate sector. This boosted economic activity beyond the level that would have prevailed with policies that we now wish, with hindsight, had been in place. That level of economic activity is the starting point for discussion of a recession, defined as two consecutive quarters of negative growth in real GDP. If we acknowledge that bad loans fueled the activity, why is it now a widely shared policy objective to maintain that level of activity?


HT: Larry White