Milton Friedman famously claimed that inflation is always and everywhere a monetary phenomenon. Later he clarified that he was referring to episodes of persistent inflation. In the short run, supply shocks can impact the price level.
Over the past decade, I’ve been arguing that trend RGDP growth has fallen to about 1.5%, mostly due to slower labor force growth (retiring boomers and fewer immigrants.) In that case, the Fed needs to generate roughly 3.5% NGDP growth to maintain its 2% inflation target.
The new GDP figures continue to show wildly excessive growth in nominal spending, with NGDP soaring at more than a 6.7% annual rate. (Please wake me up when the Fed begins its tight money policy.)
NGDP has grown by 19.2% over the past three years, whereas 10.9% growth would have been appropriate if the Fed were serious about maintaining a 2% average inflation rate. That extra 8% nominal GDP growth is 100% due to an overly expansionary monetary policy. Monetary policy cannot control aggregate supply, but it can control nominal spending.
This led me to investigate how much of our inflation problem was due to monetary policy, and how much was due to supply shocks. As of late 2021, part of the inflation problem was clearly due to supply problems. But how about today?
The most recent PCE inflation figures are for August 2022, and show the price level up 14% over the past three years. Notice that prices have risen by 8 percentage points more than would be appropriate under a 2% annual inflation target (which would be slightly above 6% over three years.) That’s identical to the excess NGDP growth. As of today, it’s all demand.
Friedman was right that persistent inflation is almost 100% a monetary phenomenon. But he was not right about the best way to identify a “monetary phenomenon”. Friedman focused on growth in the monetary aggregates, whereas many of us now believe that it is NGDP that best measures the stance of monetary policy.
Just as in the 1970s, demand side inflation has been misdiagnosed as supply side inflation. In the short run, supply shocks can indeed cause inflation to deviate from NGDP growth. But over the longer run, inflation is almost entirely driven by aggregate demand, i.e., by growth in nominal spending.
It’s the NGDP, stupid.
PS. In fairness to Friedman, the M2 money supply is up 41.6% over the past three years. So while not all inflations are caused by rapid money growth, this one is. Indeed velocity has actually slowed during this period, which means that more than 100% of the inflation comes from monetary policy as defined by Friedman. Thus, at least this time around:
It’s the money supply, stupid.
PPS. A few months back, I criticized a Robert Barro claim that we can be “highly confident” that the US entered a recession in early 2022. Today’s data effectively eliminates that possibility. (Something we already knew from many other indicators.) We may enter a recession soon (they are hard to predict), but we almost certainly weren’t in one in early 2022. Please reread my earlier post if you wish to learn why Barro made that mistake.
READER COMMENTS
vince
Oct 27 2022 at 5:10pm
1. “Please wake me up when the Fed begins its tight money policy.”
Good choice of words, tight rather than tightening. With increasing real interest rates and yield curve inversion, tightening is in place.
I’m sure the priority is a so-called soft landing. Inflation is going in the right direction. Much different situation, but look what happened in 2008 when the Fed over-reacted to inflation.
2. “NGDP has grown by 19.2% over the past three years.”
With a 2% inflation target, RGDP growth of 4% would have done it. Getting there isn’t monetary policy, but whose to say the right socioeconomic policies couldn’t get us there? Those policies don’t even seem on the radar. Actually, most of the popular progressive policies seem counter to increased productivity.
Scott Sumner
Oct 27 2022 at 10:35pm
“most of the popular progressive policies seem counter to increased productivity”
And the same applies to most of the popular conservative policies
vince
Oct 27 2022 at 11:24pm
Please consider those policies for a future article. Lack of true infrastructure improvements (transportation), educational reform including some basic economics, more conducive environment for small businesses such as lower barriers to entry, ….
Scott Sumner
Oct 28 2022 at 3:10pm
I’ve already complained about conservative opposition to high skilled immigration, free trade, zoning reforms to boost housing construction, etc.
vince
Oct 28 2022 at 8:01pm
My mention of progressive policies was not to start a debate about progressives vs conservatives. By progressive policies, I mean those that begin with precepts such as capitalism is bad, free market is bad, profit is bad, corporations are evil, nonprofit corporations are good, government is good, taxes are good, redistribution of income is good, supply and demand is meaningless, profits cause inflation, and so on.
Brian
Oct 27 2022 at 5:12pm
Is it not overstating the case to say it is “all” demand driven inflation? Suppose 3 years ago I would pay $100 for 10 quick service restaurant meals (average $10 each) and now I pay $120 for 9 (average $13.33) and then eat at home for the “missing” meal at a cost of $5 for a total of $125 spent, then part of the inflation might be due to more expensive labor… a supply constraint.
Garrett
Oct 27 2022 at 8:14pm
But why is labor more expensive? Could it be because of increased aggregate demand, not supply?
Grand Rapids Mike
Oct 27 2022 at 9:01pm
Also looked at M2 data. To be a little more specific on the M2 data, it seems that from March 2020 to March 2022 the growth was about 40% as already indicated or 20% a year. However from about March 2022 to now, M2 seems to have zero growth, so M2 growth has flatlined, a tightening of money supply may have started. It will be interesting to see what happens to inflation in the next 6 t0 12 months. It seems there several factors in play, the high M2 growth for 2 years and how long that dominates, a flattening or M2 growth for 6 months and when that starts to impact, and the energy input price, a complicating supply side factor.
Spencer
Oct 28 2022 at 11:09am
M2 is mud pie. Dan Thornton is correct. “Money Supply and Inflation: Where’s the Proof?” WSJ July 21, 2022
Link: George Garvey:Deposit Velocity and Its Significance (stlouisfed.org)“Obviously, velocity of total deposits, including time deposits, is considerablylower than that computed for demand deposits alone. The precise differencebetween the two sets of ratios would depend on the relative share of time depositsin the total as well as on the respective turnover rates of the two types ofdeposits.”
Grand Rapids Mike
Oct 28 2022 at 5:54pm
M2 a mud pie and where’s the proof. Agree M2 is a mixture – Cash, Checking Deposits, Saving etc, but they all amount to a lot of liquidity, and 20% for each of the last 2 years is not to be dismissed. Wish I could channel in Milton F. I’m sure he would have had a response to Thornton that in effect would be “are you kidding me, where do you think the current inflation came from”.
Spencer
Oct 30 2022 at 9:32am
As Steve Hanke says: “money is what matters”.
But what is money? Money is a medium of exchange. If it is not being exchanged, turning over, it does not represent our means-of-payment money.
All demand drafts clear through the payment’s system. And 95 percent of all demand drafts clear through DDs. And only 1 percent clear through non-M1 components. The economics profession has done a good job hiding that fact.
MarkLouis
Oct 27 2022 at 11:11pm
The challenge is that excess demand will always look like a series of “supply shocks” since the areas with the least supply buffer see prices go vertical first. This provides ample fodder to the “it’s just a supply issue in xyz” crowd.
Thomas Lee Hutcheson
Oct 29 2022 at 4:32pm
A negative supply shock and a positive demand shock create the same policy dilemma: how to use blunt policy instruments to geese the new set of equilibrium relative prices that will maximize real income/prevent unemployed resources.
Jens
Oct 28 2022 at 9:28am
Does this analysis also apply for Europe in the fgiven timeframe ?
Scott Sumner
Oct 30 2022 at 1:57pm
Less so than for the US. It’s NGDP growth has been somewhat high in the past year, however a bigger portion of the problem is supply side in Europe. But remember that the supply part of inflation is transitory—only the demand portion is persistent.
Spencer
Oct 28 2022 at 11:03am
N-gDp is a subset of money flows, M*Vt, in American Yale Professor Irving Fisher’s truistic “equation of exchange” (total physical transactions, T, that finance both goods and services).
N-gDp is determined by the volume of goods & services coming on the market relative to the actual, transactions, flow of money. Thus M*Vt serves as a “guide post” for N-gDp trajectories.
Gross Domestic Product: Implicit Price Deflator (A191RI1Q225SBEA)
Q3 2022: 4.0Q2 2022: 9.1Q1 2022: 8.4Q4 2021: 6.8Q3 2021: 6.2Q2 2021: 6.4
That’s stagflation.
Michael Rulle
Oct 29 2022 at 8:30am
I have devolved almost completely into my “I don’t know anything” mode. More than usual.
Yet, the economy seems “okay” to me. Then again, it usually is “okay”. The early 2000s were pretty bad—at least as far as stock markets were concerned. Then we had this Covid thing which accomplished problems in a variety of ways. Arguing over “if this, then that , if not for that other thing”. Now I think we are ignoring that.
Inflation is never good—-I think. My guess it is getting lower——-(“guess”) and will keep getting lower—slowly. Why do I think that? Just looks like a trend.
I also have the annoying perception that the world is in one giant economic re- sampling mode without replacement, which limits extremes. I have no rational explanation as to why I am feeling optimistic ——-it’s not drugs——but I am. Maybe it’s because wokeness may be disappearing. Maybe it’s because I think climate change insanity is dying.
Maybe it’s because I crazily believe we are learning how to not believe the media. And I feel cheerful that Musk ——-for who knows what reason—-has decided to throw away 44bil to get rid of that irritating Twitter.
In other words, perhaps we are growing weary of the new insanity. That would be cool even if NGDP is running hot—-as it gets less hot.
Thomas Lee Hutcheson
Oct 29 2022 at 10:37am
We know that the effect of past and present instrument settings have not yet resulted in bringing inflation in line with the Fed’s supposed targets.
I do not see what the point of of dividing up inflation into “supply shocks” and “monetary policy.” It’s always all monetary policy trying to deal with demand and supply shocks, sometimes well, sometime not so well.What changes in instrument settings and or messaging should the Fed be doing now?
vince
Oct 29 2022 at 2:18pm
” It’s always all monetary policy trying to deal with demand and supply shocks, ”
The Fed could have said, “we have an ongoing supply shock. Consequently, money supply is too high in relation to goods supply. If governments don’t start working on the goods supply problem, we have no choice but to shrink the money supply in accordance with lower goods supply. If not, we are violating our stable prices goal.”
Thomas Lee Hutcheson
Oct 29 2022 at 4:57pm
Yes, they could have said and done that, but a) that supposes that the government can in fact do something to alleviate the supply shock and b) that the Fed has single price level mandate instead of a dual mandate. In my model of Fed behavior they have set an inflation rate target that the think will be suffuent to prevent the development of unemployed resources resulting from the “thousand [demand and supply side] shocks that flesh is heir to,” given that prices are systemically more inflexible downward than upward. But an outsized shock like the COVID shrinkage and quick rebound of the labor force or the subsequent “supply chain” problems (throw in international petroleum prices), or the shift from demand for services to a demand for goods required above target inflation for a time. That inflation has persisted when the economy is back at full employment shows that the Fed got its calculations about how to set the values of its instrumental variables wrong. And the TIPS market signaled that in September 2021.
vince
Oct 30 2022 at 2:45pm
” that supposes that the government can in fact do something to alleviate the supply shock”
Each one of these can be controversial, but the government can do (and not do) things:
1. Don’t create a panic.
2. Don’t impose unnecessary lockdowns.
3. Don’t war.
4. Be aware of risks and instability from globalization.
5. End foolish, anti-productive economic policies.
Thomas Lee Hutcheson
Oct 31 2022 at 8:02am
No disagreement that some of these are things that can be “done.” I was thinking about things to address the specific supply shock to be reacted to.As to your list:
“Create panic” is a little reductive of the morass of CDC communications about COVID and the response to them.
Agree by definition. I would put it as, “provide the public and policy makers with the information to allow then to craft the highest net benefit response.”
“unjust wars”
“risks and benefits” of globalization.
Agree by definition. I would put it, “use cost benefit analysis in crafting economic policies.”
vince
Oct 30 2022 at 2:53pm
“the Fed has single price level mandate instead of a dual mandate. ”
If production looks to be down indefinitely, reducing the money supply commensurately wouldn’t necessarily reduce employment any more than it already was. Of course, that approach is easier said than done and the Fed would have to be ready to expand at that right time.
Thomas Lee Hutcheson
Oct 31 2022 at 8:12am
Even a large know to be permanent negative supply shock (Brexit, say), would still not call for a policy aimed at maintaining the price level/trajectory. With prices asymmetrically less flexible downward than upward, adjustment of relative prices to achieve a new full employment equilibrium will mean an increase in the average. In other words, it will call for above-target inflation.
vince
Nov 1 2022 at 12:20pm
“With prices asymmetrically less flexible downward than upward …”
Has anyone truly studied this claim? As Ed McMahon would have asked Johnny Carson, “How sticky is it?” Repeating the claim over and over makes it increasingly self-fulfilling. Did it exist before the Fed began inflating in 2013? Everyone accepts that interest rates and their stock portfolio can easily go down. Why not other prices?
Scott Sumner
Oct 30 2022 at 2:00pm
“It’s always all monetary policy trying to deal with demand and supply shocks,”
This is bad framing. The Fed doesn’t “deal with” demand problems, it creates them.
Thomas Lee Hutcheson
Oct 31 2022 at 12:04pm
Certainly demand shocks can occur just as much as supply shocks. What was the big shift from demand for services to demand for goods during the early pandemic if not a demand shock, or a sudden positive or negative change in animal spirits?
Jeff
Oct 30 2022 at 3:59am
Thought experiment: What if the trajectory of policy were such that everyone—all market participants: buyers and sellers, creditors and debtors, producers and consumers—woke up one day and realized that money is worth exactly half what they thought it was worth the day before?
How would this inflation be categorized by the knowledgeable with regard to dividing up demand vs. supply effects? 100% demand-driven inflation? 50-50 demand/supply? 100% supply shock?
I imagine there should be a well-defined answer for a well-posed question?
Thomas Lee Hutcheson
Oct 30 2022 at 6:25am
What does “realized it was worth half” mean? That all price offers this morning before were exactly twice what the memories and records of the day before indicated? Does this apply to all assets except “money.”
Scott Sumner
Oct 30 2022 at 2:02pm
This is actually a good question, worth a post. You are sort of describing a currency reform.
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