Is inflation real or monetary?

Source: Dallas Fed, World Market Advisors

Last week I discussed the inflation equation, the formula that Milton Friedman popularized to explain the double-digit inflation of the 1970s.


M is money, V is velocity, Y is the real economy, and P is prices. The implication was that you can’t stimulate the economic activity by just throwing money into it. All things being equal, prices would simply rise, and the real economy would remain unchanged.

But the problem is, all things are *not* equal. Friedman’s equation has fallen out of favor, especially since the Financial Crisis. In the aftermath of the crisis, the Fed created a lot of money, kept interest rates at zero, and then paid the banks to hold the extra money in their reserves. The banks responded by holding the money in their reserves at the Fed – no risk, no criticism from regulators. Monetary velocity fell dramatically, and inflation stayed really, really low.

If money doesn’t explain inflation, what does? Economists have been looking for an answer. Is it caused by too little slack in the economy, the “wage-price spiral”? This would make inflation a problem in the “real” economy, not a monetary issue. This can’t explain the stagflation of the 1970s. Prices aren’t real – they’re a signal in the economy, communicating simultaneously to consumers and producers. Hayek called them a “miracle.”

If inflation isn’t real, maybe it’s psychological. If inflation *expectations* go up, people will act like inflation is happening, making it happen. Such circular logic just begs the question, ignoring where expectations come from in the first place. It’s the flawed logic behind the “Whip Inflation Now” campaign of the 1970s.

Source: Wikipedia. Public Domain

The answer comes from understanding adaptive systems. Economies aren’t like physical systems, with differential equations that can be solved and applied. Economies are more like adaptive ecosystems, where the principals and agents modify their behavior in response to incentives. When the government distributed stimulus checks and the Fed monetized these extraordinary payments by purchasing the additional debt, a significant monetary stimulus was created. As bees are drawn to honey, spenders were drawn to that money. Some went into streaming services and Peloton bikes, drawing demand forward. Some when into online investing in “meme stocks” and cryto assets. Much of it was put into bank accounts and gradually spent on scarce goods – scarce because of the pandemic.

Source: Pixabay. CC0.

The inflation we’re seeing now is a result of “high-powered” money chasing scarce goods in the economy. There’s a reason why prices of used cars were up 40% over the past 12 months, while medical care only rose 2.7%. A recent report showed that some used car prices have risen higher than new car prices, especially for more recent models. Rather than wait for months, some folks are willing to pay extra to bring a nearly-new model home today. The combination of supply chain issues with extra cash in consumers’ bank accounts has led to excessive demand pushing prices higher.

12-month change in prices for new cars and medical care services. Source: BLS.

In the 1980’s the Fed lifted interest rates dramatically, cutting into bank profits and curbing bank lending, thus choking off the growth of bank-created money. When the Fed raises rates next month, they won’t put cars on dealer’s lots, nor will they reduce demand for medical services. The excessive money flowing through the economy won’t be eased by the Fed raising interest rates, because it wasn’t created by low interest rates. When the Fed raises rates next month, don’t expect that to change the inflation equation.

Low interest rates didn’t cause inflation. Raising them won’t stop it. That will happen as people get back to work and the economy becomes productive again. But don’t be surprised if the politicians take credit.