What causes inflation?

Source: Cleveland Fed, World Market Advisors

I’m old enough to remember public service ads on television asking us that very question. They had characters playing grocery shoppers, business managers, and blue-collar workers. The ad blamed shoppers for not looking for the best deal, managers for raising prices just to maintain their profit margins, and unions for being to aggressive when they negotiated their contracts. The ad’s conclusion: “Who causes inflation? We *all* do.”

It turns out that it’s not so simple.

In 1970 Milton Friedman penned his famous line: “Inflation is always and everywhere a monetary phenomenon.” The notion seems intuitive. If an economy produces a given amount of goods and services, but we flood the system with more money, prices must increase. Friedman was so committed to his formulation that he put the formula onto his California license plate:


Where M is the quantity of money, V is its velocity or turnover through the economy, Y is the quantity of goods and services, and P is the general level of prices. He thought inflation worked like the gas laws in physics: add to the money supply, and you’ll necessarily add to the price level.

(A side note: the State of California didn’t have an equals sign on their license plates, so Friedman added two pieces of tape to his plates to make his point, which occasionally got him in trouble with the highway patrol.)

Source: Twitter

Friedman’s monetary equation was severely put to the test in recent years in the aftermath of the Financial Crisis. Central Banks around the world engaged in “quantitative easing”, purchasing government bonds and other assets in order to increase the money supply and stimulate the economy. There’s no question that the money supply went up dramatically over the last decade. But the velocity of money slowed dramatically as well. Friedman’s equation is still valid, but all other things were not equal.

The monetary theory of inflation was considered dead. Then came the Covid stimulus.

In the aftermath of the crisis, the Federal government distributed about $3 trillion to consumers, both directly and indirectly. It wasn’t just stimulus checks and tax refunds, it was also forgivable Paycheck Protection loans, Main Street lending, a Municipal lending program, and an alphabet soup of support programs. These direct payments to consumers were funded by the Fed’s purchase of US Treasury Bonds. This combination of the Treasury and the Fed (dubbed T-Fed) created trillions of dollars and channeled them to the people most likely to spend them.

The economy has been slow to get back to full strength, with worker shortages, supply chain issues, and excess demand pushing up commodity prices. Too many dollars are chasing too few goods. The result has been the highest inflation figures since the early 1980’s. Even compensating for the drop in prices during the pandemic, the inflation is higher now than it has been since the early 1990’s. And it began to accelerate as the economy began to open up in the spring of last year, right about when most people were vaccinated. Turns out it’s not enough to win the war against the coronavirus. We also need to win the peace.

So how should the authorities respond to inflation?

They can stop adding money to the system. That’s clear. In the middle of March 2020, markets experienced an “everything sale” as institutions liquidated everything they could to raise ready cash – cash needed to sustain operations with a shut-down economy. Treasury Bonds experienced almost as much volatility as stocks. I hadn’t seen an everything sale since October 1987. This time the Fed did what the Fed couldn’t do back then. They stepped in as the buyer of last resort, supporting markets in all kinds of securities around the world. As the shutdown continued, the Fed continued to support the markets by purchasing the Treasury’s debt.

But that time is over. Markets have been in a melt-up, not a meltdown. There’s no need to provide additional monetary stimulus to the economy.

But how about lifting interest rates?

Historically, this is how the Fed fought inflation. When interest rates are below the inflation rate, this creates a negative “real” interest rate, stimulating debt formation and money creation. By raising real rates, the Fed increases the marginal price of money, reducing demand. In addition, lifting short-term rates reduces banks’ profitability. Less profitable banks make fewer loans, slowing the creation of new money. Raising interest rate slows the economy.

But higher interest rates won’t create more goods. It won’t put people back to work. It won’t deliver groceries into missing shipping containers. It won’t put new cars onto dealer’s lots. In a time when people are using their cars more – using less public transport, living further away from city centers – new cars are hard to find, and good used cars are even harder. At least half of the inflation equation has to do with the supply of goods and services.

Sure, the Fed can curb the growth of money. But they can’t supply the goods.