The news that the Consumer Price Index rose 4.2 percent in the twelve months ending in April has shocked the financial commentariat. But such inflation is hardly inexplicable. Between President Biden’s COVID-relief package and (much more relevant) the Federal Reserve’s continued asset purchases, aggregate demand is getting a healthy boost. Supply conditions are improving, but not fast enough to prevent generalized price increases.
How worried should we be about this sudden inflationary pickup? The short answer is, not very. Inflation in the 3–5 percent range, so long as it’s temporary, is no cause for panic. In fact, rising prices come with a disguised blessing: They could force the Fed to end the irresponsible monetary policies it’s employed over the past year.
The place to start when talking about inflation is the equation of exchange, MV=Py. M stands for the money supply, V for the velocity of money (its rate of turnover), P the price level, and y real (inflation-adjusted) GDP. It’s helpful to express the equation in terms of growth rates: gM+gV=gP+gy. Solving for inflation, we get gP=gM+gV-gy. Faster growth in the money supply and its rate of turnover yields higher inflation, and higher real-GDP growth yields lower inflation. Since aggregate demand (gM+gV) is currently outrunning productive capacity, we’ve got comparatively more purchasing power chasing comparatively fewer goods.
Looking at the data for the money supply and velocity, it’s clear that the former is where the action is. But why is the money supply increasing now? After all, the Fed conducted massive asset purchases during and after the 2008 financial crisis, and the money supply hardly budged then. The answer is that the Fed isn’t paying banks not to lend anymore. Interest on excess reserves is down to 0.10 percent. With payments on idle liquidity near zero, we’re as close now as we’ve been in more than a decade to the old, pre-financial crisis operating framework for monetary policy. And that’s a good thing.
Between 2008 and 2020, American monetary policy took a strange turn. The time-tested link between the size of the Fed’s balance sheet and the price level broke down. This gave the Fed lots more wiggle-room to engage in expansive, and unnecessary, credit allocation, picking winners and losers in the financial system. We don’t want the central bank doing this, because it invites the politicization of monetary policy. Imagine how Congress would react when it learned that it could use the Fed’s balance sheet to finance the latest harebrained partisan scheme. The Fed is already far less politically independent than is widely understood. What independence it does have must be preserved.
Higher inflation means that the Fed cannot continue its massive asset purchases unless it’s willing to risk even greater price increases. But the political pressure to continue easy-money policies undoubtedly remains. After all, the Biden administration has already demonstrated that it is happy to force purchasing power down the economy’s throat. One hopes that the Fed will politely tell the president to mind his own business.
But ultimately it’s not inflation itself that’s the problem; it’s the unpredictability of inflation. And here there is a second potential silver lining: Consumers hate inflation, so we might get some political support for genuine monetary rules, and perhaps some fiscal reform, too. The Fed has for too long been its own arbiter. The inflation spike could precipitate some real procedural improvements, including a strict target rule for monetary policy. Ideally this would happen at the same time as spending reform, since fiscal and monetary policy have a nasty habit of enabling each other’s worst excesses.
This perspective on inflation is pretty dovish. Is there a compelling argument for hawkery? We have already discussed one: If the Fed refuses to recognize reality and start behaving responsibly, inflation could continue to climb. While 5 percent inflation isn’t worth crying over, 10 percent inflation is. Prices rising that fast can do terrible damage, as we learned the hard way in the 1970s. The Fed’s relatively new “average-inflation targeting” regime effectively gives it a “respectable” reason to print money longer than is prudent. Since the Fed is targeting 2 percent inflation on average, rather than each year, it can always point to unusually low inflation yesterday to justify high inflation today. On paper, average-inflation targeting is a good thing, because it stabilizes prices: If people know what the purchasing power of money is going to be 30 years from now, long-term planning becomes much easier. But once you recognize the various information and incentive problems created by central banking, maybe you don’t want the policymakers to have so much latitude.
The Twitterverse is exploding with fears of a Jimmy Carter–esque economic malaise. But while the misery index — the sum of unemployment and inflation — is clearly higher than we’d like right now at about 10 percent, we are nowhere near the level of dysfunction that prevailed on the eve of the 1980 election. Everyone should take a deep breath. Chances are that things will be fine.