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Getting to Know Inflation
It's a monetary phenomenon -- but there's a little more to it.


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Larry Kudlow

There’s no foolproof way to forecast inflation — a big buzzword these days. The Milton Friedman definition of too much money chasing too few goods is always a good place to start. But we’ve learned through the years that simply using a monetary aggregate to predict inflation doesn’t work. This is because the velocity — or turnover, or demand — for money is not stable. It hasn’t been since President Nixon took us off the Bretton Woods gold-exchange standard. Nowadays, there’s no policy anchor to reliably preserve monetary value.

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Begin with the Fed, the only place new money can be created. Excess money is inflationary, where dollar purchasing-power value falls. A shortage of money is deflationary, where dollar value rises. Though pure monetarism has dimmed, the model of too much money (created by the Fed) chasing too few goods (money required for financial and economic transactions) is still useful.

Economist Arthur Laffer pioneered a sub-division of traditional money-supply measures into supply and demand categories. Through the monetary base, the Fed controls the true supply of money. With transaction balances, such as M1 (currency and demand deposits) or MZM (money at zero maturity), the public’s demand for money can be quantified.

Over the past year, these money supply-and-demand proxies are in balance. But core inflation has still gone up. Measured over a twelve-month period, the consumer price index has increased to 1.8 percent in May from 1.1 percent last December. Year to date, the core CPI (excluding food and energy) is advancing at a 2.9 percent annual rate.

Importantly, monetary policy also interacts with tax policy. Lower marginal tax rates usually raise liquidity demands as higher after-tax returns to work and investment generate increased economic activity. Hence, more money from the Fed is required to finance the economy’s expanded potential to grow. This has certainly been the case in the year following the Bush tax cuts.

As economist Victor Canto has long argued, supply-side tax cuts raise the volume of available goods and services, thus absorbing any monetary excess. Think of it as more money chasing even more goods. This is profoundly counter-inflationary. In fact, it is the reason why virulent inflation seems highly unlikely today.

But most academic and Wall Street economists are demand-siders. They believe that excess demand during times of rapid economic growth causes higher inflation. Twenty years ago Lawrence Summers and Paul Krugman, then staffers on the president’s Council of Economic Advisors, predicted higher inflation after the Reagan tax cuts. They were dead wrong. Inflation declined to 1 percent in 1986 as the volume of goods surged during the Reagan boom.

This supply-side fiscal effect strongly suggests that inflation is not only a monetary phenomenon. But how can we forecast it?

Inflation-sensitive market prices best capture the relationship of money supplied and demanded. Prices efficiently encapsulate all available information regarding the inflationary or deflationary processes. Friedrich Hayek’s “knowledge problem” is best solved by markets, not government.

This discipline is fleshed out in “Monetary Policy, A Market Price Approach,” by Manuel Johnson and Robert Kelleher. The authors, both of whom served in the Federal Reserve System, draw heavily on the classical theories of Swedish economist Knut Wicksell. In the Wicksell system, future inflation expectations can be charted through the movement of gold and commodities, the exchange value of the dollar, and Treasury-bond spreads. When the Fed policy rate is set below the economy’s real or natural rate, inflation fears will rise. When it’s set above the real rate, deflation fears will develop.

Between 1996 and 2002, the economy experienced episodic deflation. Since then, however, emergency liquidity and rate-cutting by the Fed have caused sensitive market-price indicators to signal a revival of inflation expectations. Essentially, the Fed lurched from too tight to too loose. How much of a problem will this be?

A shorthand version of the Wicksell model has been developed by Wall Street supply-siders Michael Darda and Michael Churchill. They compare the current dollar price of gold with the 10-year average gold price, with Churchill using the pre-deflation period of 1986 to 1996. Both gentlemen acknowledge the emergence of excess liquidity in the form of a rising gold price in 2002 and 2003. However, both note that the recent slump in gold (and metals) suggests that rising inflation pressures may turn out to be rather muted. Still, the Fed must remove the unnecessary emergency liquidity and raise its base target rate.

If they do, inflation will turn out to be a non-problem.

Think of this: The Bush tax cuts, along with rapid productivity gains and hopefully a steady dollar-gold exchange rate, could recreate the economic booms of 1982-1989 and 1995-2000. In both periods, economic growth came in above expectations and inflation below them. Certainly, the better part of economic and market wisdom today still suggests that an optimistic outlook is far more likely than a pessimistic one. This would be very good news for George W. Bush — for as go the markets, the economy, and inflation, so goes his re-election prospects.

— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.



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