High inflation continues to squeeze American’s living standards
Last week, at the unveiling of his official White House portrait, President Obama said to President Biden: Thanks to your decency and strength, maybe most of all, thanks to your…
In the year to December, the Consumer Price Index (CPI) rose by 7 percent, its fastest rate of annual increase since June 1982. “Core CPI” — which excludes more volatile food and energy prices — was up 5.5 percent from a year ago, the fastest rate since February 1991.
Monetary economics can seem like one of the more daunting aspects of the discipline. Quoting Lenin, John Maynard Keynes once wrote that “not one man in a million” understood the mechanics of inflation. But with our incomes being squeezed – and inflation is running above the national average in the Midwest and Twin Cities – Minnesotans cannot afford to remain so ignorant.
Fortunately, its mysteries are not be beyond the layperson willing to devote some clear, careful thinking.
Looking back over decades of data, we see a close relationship between changes in the CPI – inflation – and changes in the quantity of money per unit of output. From this observation comes Milton Friedman’s famous – often truncated – quote: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
From this perspective, current inflation is no mystery. From the fourth quarter of 2019 to the third quarter of 2021, real GDP – Gross Domestic Product, or output – increased by 1.4 percent.
Meanwhile, from December 2019 to November 2021, the amount of money according to the M2 measure increased by 39.9 percent.
With the quantity of money relative to output rising so sharply, we should have expected the CPI to rise sharply also. There is more money chasing relatively fewer goods, bidding their prices up.
Behind this expansion of the M2 money supply lies an expansion of the Monetary Base – which comprises all reserves held by banks as well as all currency in circulation – which is under the direct control of the Federal Reserve.
Between December 2019 and November 2021, the Monetary Base expanded by 86.6 percent as the Fed printed money and bought financial assets – the Total Assets held by the Fed has increased by 110 percent since Jan. 1, 2020. The financial institutions that had sold the assets used the new cash as the basis for expanding credit, which lead to the expansion of M2.
That is the cause of our inflation.
For the rate of inflation to fall, the quantity of money per unit of output will need to fall or, at the very least, stop increasing at current rates. This will require either a falling or decreased growth rate of the quantity of money or an increased growth rate of real GDP.
The latter is unlikely. After a strong snapback in late 2020, the growth rate of real GDP is falling back toward its recent historical average. Even with supply-chain issues resolving, it is highly unlikely to achieve the rates of growth necessary to “sop up” the new money created in the last two years anytime soon.
So it falls to the Fed to fight inflation by slowing and eventually terminating its purchases of assets with newly printed money. Even here, though, there will be a considerable overhang. The gap between the growth of the quantity of money per unit of output and increases in the CPI is wide by historical standards, so that even if the former stopped growing today, the latter would still have some catching up to do. Even if the Fed acts now, inflation is likely to remain at elevated levels for some time yet.
If neither happens then, to re-establish that historic relationship between changes in the quantity of money per unit of output and changes in the CPI, it will be the CPI which will have to adjust at even higher rates or over an even longer period – persistently higher inflation, in other words, with the ongoing squeeze on living standards which that entails.
To paraphrase another Bolshevik, “You may not be interested in monetary economics, but monetary economics is interested in you.”
This op ed originally appeared in the Pioneer Press on Feb. 2, 2022.
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