If Fed acts wisely, expect inflation rate to regress

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In a New York Times op-ed in January, Paul Krugman commiserated with those blindsided by the jump in the U.S. inflation rate. Quoting him: “A 7% surge in the Consumer Price Index over the past year comes as a shock, especially because so many people, myself included, didn’t see it coming.”

It seems to me that no one with some familiarity with economic theory should be in the least surprised at what has happened.

A good place to begin any discussion about inflation is with one of the most well-known claims in economics, made by one of the most well-known economists of the 20th century, Milton Friedman, a Nobel laureate and professor of economics at the University of Chicago: “Inflation is always and everywhere a monetary phenomenon.”

What does that mean? Simply that an economy’s inflation rate is closely related to the rate at which its money supply is growing. Money is the currency in circulation, plus balances in various bank accounts, and the inflation rate is the percentage change in average price from period to period. What Friedman argued is that the rate at which the money supply grows will determine the inflation rate. In fact, there could be a simple relationship between these two percentage changes. Here’s the relationship I’m alluding to. Say the money supply is growing at the rate of 6% a year, and the inflation rate is 3%. Then if the rate at which the money supply is increasing goes up to 9%, the inflation rate would go up to 6%. Every 1 percentage point increase in the rate at which the money supply is growing could cause the inflation rate to go up by 1 percentage point.

Other factors might need to be considered when trying to understand why the inflation rate has gone up. But many economists would say this is the appropriate starting point. In any case, let’s start there, by looking at some data on the Consumer Price Index and the money supply.

Let’s look at how the CPI changed over time vis-a-vis how the money supply, known as M2, changed over time. The dates I picked were arbitrary. The first of the year is as good a time to take a measurement as any, up to 2020. I gave the pandemic a couple of months to “percolate” through the economy and then looked at the change in values from May to May. November was the most recent month for which the numbers for the CPI and M2 are available, and so I also looked at the changes that have occurred from May to November 2021.

What do we see? One, the inflation rate from 2012 to 2019 was pretty low, just under 1.5%. It went up a percentage point the next year, to 2.5%, and then it doubled to just under 5%. This past half-year, the annual inflation rate reached 7.5%.

Why? Well, look at how the money supply has been changing over the same period. From 2012 to 2019, it increased at an annual rate of 5.64%. From 2019 to 2020, it increased by 6.67%, faster but not too much out of line with the past eight years. Then, along comes the pandemic and from May 2020 to May 2021, the money supply increased by 14.1%. That’s a big jump. Over the past six months, the money supply has increased by just under 10% on an annual basis, still very much above what has been the norm.

I’m not sure we have to look any further for a reason for the jump in the U.S. inflation rate. But maybe this is too simple a story for some. So, what else should we bring into the picture?

One of these is the rate at which the economy’s output is increasing over time, or the economy’s growth rate. When that goes up and everything else stays the same, the inflation rate should fall, and vice versa. The pandemic put a damper on “economic activity,” the buying and selling of goods and services. People didn’t go shopping, and they didn’t go to work, and from the fourth quarter of 2019 to the second quarter of 2020, output decreased by about 10%. In fact, over the past two years, the annual growth rate has been under 1%, less than half of what would typically occur.

Is there anything else to consider? Well, there is a third variable that could affect the inflation rate, which is how quickly people spend money. Think about that. Say the Federal Reserve prints $1,000 and gives it to me as a gift. What if I don’t spend it and put it in the proverbial cookie jar? Then that injection of money into the economy doesn’t generate any spending and therefore, it doesn’t put any upward pressure on prices. As it happens, people were spending money more slowly in the third quarter of 2021 than in the first quarter of 2020. This put a bit of a brake on inflation. Had it gone the other way — if people started to spend money more quickly — the inflation rate would have gone up even more.

In view of these facts, no one versed in economic theory should be surprised by what we’re seeing right now. What would be hard to understand is an inflation rate that continued to hover around 2%. That would be something of an economic mystery.

Of course, people are probably more interested in “what’s next” than in “why this.” What can we expect in the near future? If wage and salary increases lag behind price increases — and they may in periods of rising inflation — then inflation means, effectively, that you and I have a little less money to spend. However, most people would probably agree that there’s something worse than having a little less money to spend. That’s having no money to spend. In other words, losing your job. That’s one of the dangers of reining in inflation too quickly. The unemployment rate rises. Not forever, but that’s little consolation to someone out of work for a year. Unemployment makes people unhappy, and many of those who are less unfortunate than the people who lose their jobs, nervous. Everybody in the economics profession knows this, and consequently, I would guess the Federal Reserve is going to be very careful about changing monetary policy, about reducing the rate at which the money supply is growing.

But seeing the growth rate of the money supply has gone down makes me think the people at the Fed are working to bring that rate back down to where it’s been for the past 10 years. And if they do, my guess is this is all going to go away. The inflation rate is going to fall back to the neighborhood of 2%-2.5%. As I said, I think the Fed will be very judicious in ratcheting the growth rate of the money supply back down to 6% a year. However, whether it will or not is certainly beyond my ken. And perhaps people of such professional eminence are privy to trends and facts that I can’t even guess at. So, we’ll see. 

Jon Neill is a professor in the Department of Economics at Western Michigan University.

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