Hummel on Whether to Expect Higher Inflation
By David Henderson
About a month ago, I called Jeff Hummel, a monetary economist and economics professor at San Jose State University, to ask him whether he thought there would be a substantial increase in inflation due to the substantial drop in real GDP with no drop in the money supply. MV = Py. M increases, y falls, and so P (the price level) must rise, assuming V is relatively constant. As you’ll see below, V has fallen, which means that maybe P doesn’t have to rise much.
I had a more-practical interest than usual. At the time I owed about $48K on my mortgage and the interest rate is fixed at 3.39% per annum. So, other than a few gold coins I own, my mortgage interest rate is my main hedge against inflation. Jeff didn’t have a complete answer. Then I read a post by George Selgin that made me relax about inflation. I decided that paying down about $5K of my principal on my mortgage was a good idea because the reality was that that $5K would simply sit in the bank earning very little interest and the interest would be taxed. Paying down the principal on a 3.39% mortgage, by contrast, would earn me an after-tax rate of almost 3.39%. The reason is that I no longer itemize for my federal taxes and so get no federal tax break on my mortgage interest. Why almost? Because I do get a state tax break. My state marginal tax rate is 9.3%, so the net of tax return from paying down my mortgage = 3.39 * (1 – 0.093) = 3.07%.
Over the last couple of months, several people have asked for my opinion about the prospects for future high inflation, given the Fed and Treasury responses to COVID-19. I was so busy teaching online that I had no time to look into this question. But now that my teaching semester has ended, I do have a few preliminary thoughts that I can pass along.
Normally a severe supply-side shock to the economy, as created by the government’s lockdown, would alone cause a spike in the price level. But by also inhibiting people from spending money, the lockdown has induced a decline in money’s velocity. By reducing aggregate demand, the fall in velocity tends to dampen the impact of the supply shock on the price level. To give one anecdotal example of this increased demand to hold money, David Henderson and I recently discussed how drastically our credit card bills have declined over the last two months. This is a point that George Selgin alluded to in this post: https://www.alt-m.org/2020/04/27/return-of-the-inflation-mongers/. The decline in M2 velocity is quite visible in the monetary statistics, but to what extent its impact on aggregate demand will be offset by future Fed policy is something I need to explore further.
One person who argues that Fed policy will not generate future inflation is David Beckworth, in this article for National Review: https://tinyurl.com/yau48eak. David makes some interesting arguments. The one I found most intriguing is his claim about dollars moving abroad. To the extent that dollars flow abroad, this also dampens inflation. If the dollars held abroad take the form of deposits, they do not show up in U.S. monetary statistics. But if they are in the form of currency, they do give an upward bias to U.S. monetary statistics, which have never made any distinction between Federal Reserve notes held domestically and those held abroad. The upward bias is most significant for the monetary base, a point David Henderson and I made in our 2008 article about Greenspan’s monetary policy. But currency in circulation is still 10 percent of M2, and a quick glance showed that its rate of growth increased at about the same time as M2’s rate of growth increased. How much of that increase in currency represents foreign holdings is worth investigating, although it may be hard to determine.