‘Inflation is always and everywhere a monetary phenomenon,” said Milton Friedman in 1963. This might be his most-quoted remark, and yet, strangely, those who invoke it usually omit the rest of the sentence: “And [inflation] can be produced only by a more rapid increase in the quantity of money than in output.” We should be paying especially close attention to the latter half today.
Friedman is describing how inflation is brought on by too much money chasing too few goods. There are two ways we can get persistent price increases: faster money growth or slower output growth. (Of course, we could have both at the same time.) This approach to inflation usefully distinguishes between demand-side and supply-side causes.
Demand-side inflation derives from expansionary monetary policy, pursued by the Federal Reserve. When the Fed purchases assets with newly created money, increases in the money supply eventually drive up prices. This simple story has gotten more complicated since 2008, when the Fed began paying interest on excess reserves. Banks had an incentive to park the new money in their accounts at the Fed. The monetary base went up, but the broader money supply hardly budged. Today, however, there are no excess reserves, because the Fed suspended reserve requirements last spring as part of its pandemic response. Now the Fed pays interest on general reserves. The current rate is 0.15 percent, while the target range for the federal-funds rate, the Fed’s traditional policy barometer, is 0 to 0.25 percent. We’re closer now to the textbook policy framework than we have been in a decade.
Many commentators look at the Fed’s ramped-up asset purchases since March 2020 and infer that there must be lots of inflationary pressure on the demand side. But we must be careful. To create that pressure, it’s not enough to grow the money supply; the money supply must also grow faster than money demand. Just like other goods, the price of money — its purchasing power — is determined by supply and demand. You can’t know what’s happening to the price of money without looking at both.
The money supply did begin to grow quickly in March 2020 — but money demand rose sharply, too. The overall result on nominal income, what economists call “aggregate demand,” shows a fast recovery after the darkest days of COVID, followed by a higher growth rate. This suggests that the Fed’s monetary policy in response to COVID was reasonable. (Its credit policies are a different story. These were fiscal operations in disguise, which the central bank never should have tried.) And while demand is growing faster than before the crisis, that by itself can’t explain current inflation.
Enter the supply side. You’ve doubtless heard the stories about container ships unable to dock and unload, goods piling up in warehouses for want of transport, and trains backed up for miles at rail depots. Markets for important inputs, from energy to semiconductors, are feeling the squeeze. Furthermore, the latest jobs report showed a measly 194,000 jobs created in September. All of this screams supply problems.
For a given rate of aggregate-demand growth, we’ll get more inflation when aggregate-supply growth slows. There’s nothing central bankers can do about this. Other policy-makers can help by loosening regulations that would otherwise make it more costly to produce and distribute goods. But even then, there’s only so much that policy can accomplish. Inflation will probably remain elevated until the supply constraints ease.
Our interpretation of inflation changes significantly when there are supply problems. Goods are getting more expensive in general because, compared with money, they’re relatively scarce. Inflation is a by-product. To the extent that households are worse off, it’s because goods are hard to get, not because prices are going up. The greater hardship comes from the reduction in consumption power caused by supply shortages. Think about it this way: Is the public worse off when prices are high and goods are available, or when prices are low and goods are unavailable?
This brings us to the Fed’s upcoming taper. While I’m all for normalizing monetary policy, there’s a chance we’ll learn the Achilles’ heel of inflation-targeting the hard way. If the Fed is concerned about inflation, they’ll tighten policy. That’s what the taper is: a slowdown in the rate of asset purchases. Central bankers could reduce purchases by $15 billion per month starting in November. But if inflation has a significant supply-side component, forcing the economy to adjust to a new, lower level of demand, it will spell trouble for both labor markets and goods markets. Economics textbooks warn of the dangers of targeting inflation when supply is unstable. In terms of real output, those supply problems could cause aggregate-demand restraints to make things worse, not better.
Inflation is complicated, and truncating Friedman quotes only undermines our ability to understand it. Friedman himself was much more nuanced than the reductionist version of him that’s trotted out whenever inflation rises. We should live up to his rigor, not drag him down to our punditry.