January’s headline inflation of 7.5% was the highest in the United States in forty years. Consistent with previous months, the biggest driver of higher prices was energy, rising 27%, but cars and groceries (especially proteins) also pressured the numbers.
While Fed Chairman Powell had retired the word “transitory,” he and other officials have stopped short of characterizing the inflation as “persistent,” a phrase loaded with negative connotations for economic historians. Rather, what economists and business practitioners now seem to be invoking is a pricing plateau, a one-off re-leveling, resulting from the unleash of post-pandemic demand combined with a lag in supply. Because of lockdowns, travel restrictions, vaccine mandates, recently reimposed energy regulations, and other sources of supply chain disruptions, aggregate supply has fallen, but will eventually rebound.
In this view, inflation emerged from pandemic-related fiscal stimulus and economic reopening, which roused demand more quickly that supply could recover. Illustrating the point, Jackson Hole Economics’ Alex Friedman and Larry Hatheway argue that the dramatic rise in “prices and wages reflects a massive – but one-time – shift in demand relative to supply. … It is a misdiagnosis to confuse a one-off rise in the price level for … inflation.” Once these forces rebalance, inflation should abate, and prices stabilize.
I take a contrary view. As another Friedman (Milton) points out, inflation is always and everywhere a monetary phenomenon. US money supply mushroomed following the global financial crisis. Monetarists declared that inflation would necessarily follow, but it failed to arrive when predicted. Keynesians seemed vindicated. So why is price inflation emerging only now, well over a decade later, when least expected?
The lag in price inflation resulted because private sector spending didn’t rise with the money supply. In fact, while the money supply tripled, the velocity of money (the rate at which money gets spent) fell by half, reflecting serious weakness in the economy. Yet all that new money needed to find a home, so asset bubbles emerged instead. An inflationary crisis was building for over a decade, pandemic effects unleashed them, and they will not normalize until prices have risen to better approximate the trebling of the money supply.
Let’s be more specific. U.S. money supply (M2) has grown by 2.9x over 15 years. Indeed, in the two pandemic years, M2 grew by over 40%. Smoothing out this recent acceleration, money supply has grown by 8% per year since January 2007. All else equal, this would have implied the price level should also have grown by a similar amount, i.e., 8% annual inflation. Yet PPI and CPI only grew between 2% and 3% annually over this time. So what happened? Where was the inflation than many warned would result from massive quantitative easing?
The answer is found in “unrealized inflation,” i.e., the typical lag between money supply growth and price inflation. What the history of post-war German and American inflations reveals is that it can take several years for price inflation to emerge following even dramatic increases in money supply. As Ronald Marcks demonstrated in Dying of Money, inflation eventually reaches somewhere between 60% and 100% of the increase in money supply, depending on other factors in the equation, but this process can take time.
The price level is simply the product of the quantity of money and its velocity, divided by aggregate values in the economy (roughly, GDP plus national wealth). Following the global financial crisis, money velocity fell steadily for over a decade – from 2.0 in early 2007 to 1.4 in 2019. Velocity then collapsed to 1.1 during peak lockdowns (2Q20) and hasn’t budged since. Thus, the only factors currently in play are the quantity of money in circulation and aggregate values.
It’s important to note that while in early stages of inflations, money supply exceeds price growth, in later stages of inflations, prices increase faster than money supply, creating a vicious cycle and the need to print more to meet money demand. During both periods, governments and corporate interests – both beneficiaries of inflations – typically blame the inflation on anything and everything except for its cause … the rise in the money stock.
Weimar Germany illustrates the point. The inflationary cycle lasted nine years before it was finally and painfully broken. There were less than two years of skyrocketing hyperinflation, and this only at the end. Initially, prices held even as the money supply doubled. This encouraged government to keep spending, as no consequences emerged. The stock market exploded, P/E ratios ballooned and dividend paying shares fell out of fashion long before prices accelerated. It took eight years of money supply increase, during which time prices initially increased relatively moderately, before hyperinflation caused the economy to collapse. There is a risk that the United States is at an early stage of a similar cycle.
Keynesians will dispute this and point to deflationary Japan and elsewhere as counterfactuals. Japan is unique because of the dizzying heights from which it fell. The dramatic decline in velocity and destruction of national wealth in the 1990s more than compensated for the roughly doubling of its money supply over thirty years. But this is a debate for another time.
A highlight of the money supply issue is not to discount the supply side dynamics. Supply chain disruptions and labor shortages have certainly contributed to rising prices, and these factors were the likely catalyst of the delayed inflation. Pandemic relief stimulus programs created incentives for individuals to avoid returning to the workforce, leading to the Great Resignation. These programs have now come to an end, yet tight labor markets continue, manifesting in a shortage of truck drivers, airline crews, warehouse staff, and retail and hospitality workers.
Residual pandemic policies that shuttered manufacturing plants and restricted access to border entry facilities have led to massive backlogs at our ports. Vaccine mandates, passports, and similar restrictive measures have made matters worse. They are short-sighted and unnecessary in a population with over 200 million fully-vaccinated against a now endemic virus. These policies exacerbate labor shortages and supply chain disruptions without providing any offsetting benefit. Legitimate national security concerns regarding imports of telecoms, semiconductor and other technologies have nonetheless exacerbated the situation.
Sanctions and other effects related to Russia’s invasion of Ukraine, coincident with the Biden administration’s hamstringing of domestic supply from fracking and shale reserves and pipeline projects like Keystone XL, will almost certainly further pressure energy prices at the pump and at home. Energy is fueling America’s inflation. The cause is a poor policy framework that squanders our strongest natural resource by undermining our oil and gas industry, and which threatens American energy security and independence at a dangerous geopolitical moment.
Marcks said it well nearly fifty years ago: “If there is any lesson to be learned from a study of inflations, it is that one never knows where he is in the midst of it, but he is certainly not where he appears to be.” If the monetarist view holds in this current cycle, inflation will persist, even after supply normalizes to meet demand. If the price level to money supply growth ratio holds as a rule of thumb, inflation in the 8%-12% range may continue for several years.
This will result not only from a catch-up to the historical growth in money supply, but also from new monetary expansion as the national debt, now at 133% of GDP, continues to grow to fund wasteful deficit spending. This will continue to be monetized by the Federal Reserve, just as it has since 2020. Debtors win, and creditors lose, in inflations. Overly indebted governments, typically the largest debtor, only have three choices in times like this: repudiation, specific taxation, or generalized taxation through inflation. Governments always and everywhere choose sustained inflation. This time will be no different.