After Covid, inflation in the US – and worldwide – soared to levels not seen since the 1970s. And during that time, we’ve been treated to a steady stream of proclamations that economists were blindsided by it. And as economists argued about supply-side vs demand-side explanations, more off-the-wall theories took the opportunity to muscle their way back into the discourse.

But what if I told you you could have predicted both the onset and the end of the post-Covid inflation almost perfectly, just plugging public numbers into a back-of-the-envelope model?

Hindsight is 20/20 of course, so here are the receipts.

  • December 2020: We should be worried about inflation as the economy recovers. (Annualized inflation was at 1.2% at the time, still well below the Fed’s 2% target)
  • July 2022: 1.5 more years of inflation if the Fed doesn’t do anything more; less if they do. (Economists were arguing whether inflation would be ‘transitory’ or ‘permanent’ around this time)
  • April 2023: There won’t be a financial crisis or recession until the CPI catches back up to M. (Economists were debating whether inflation can be brought down without a recession – a “soft landing” – around this time)
  • July 6, 2023: Inflation is just about over.

And on July 12, new inflation numbers put June’s inflation at 3% annualized, to widespread cheers of Soft Landing and the End of Inflation. Four for four.

These predictions don’t come from anything more complicated than a back-of-the-envelope Quantity Theory of Money. In the long run, the price level tracks the money supply. I challenge you to find a model with a better track record over the past three years.


 The Quantity Theory: Back from the Dead?

“But wait,” the monetary policy wonk will say, “didn’t we ditch the Quantity Theory in the 80s? And what about the demand for money? Wasn’t it too unstable for the Quantity Theory to be useful?”

The Quantity Theory did have a brief time in the limelight after the 70s discredited more elaborate Phillips Curve explanations. But indeed, the quantity of money stopped predicting variables like inflation and NGDP growth very well in the mid 80s. So going into the 90s, policymakers started relying more on interest rates as a guide to monetary policy, eventually settling on rules (like the Taylor Rule) and models (like the New Keynesian DSGE) that don’t involve the money supply at all.

These models failed notably during the 2008 crisis, but – the conventional wisdom goes – it’s not clear the quantity theory would have done any better. If you were looking at the monetary base in 2008, which quintupled over several rounds of quantitative easing, you should have expected hyperinflation – as many Austrians at the time did. If you were looking at M2, which grew mostly smoothly, you wouldn’t have expected anything amiss – as many Fed economists at the time did not. In retrospect, neither of these were good predictions.

Nevertheless, a growing body of theory and evidence suggests we may have buried the Quantity Theory too hastily. What if M0 and M2 were the wrong quantities the whole time?


What Is the Quantity of Money?

At first glance this seems obvious enough: the quantity of money is all the stuff you can spend as a medium of exchange. As every econ major learns, we have a quantity of base money – cash and bank reserves – and then larger quantities of privately issued bank deposits that we add to get M1 and M2.

But what if you’re not indifferent between cash and deposits? Does it make sense to add together two quantities of imperfect substitutes? What about other media of exchange that don’t get counted at all in M2, like Treasury bills, commonly used as collateral in financial transactions? If these sorts of assets make their holders feel more liquid – that is, that they can spend more easily – aren’t they money too?

Of course we can’t just add the total value of Treasuries and commercial paper and whatever else to the money supply without dwarfing it and getting a nonsense measure. What we can do, however, is treat them as money-like. And we can identify money-like assets if they provide a rate of return below the risk-free market rate. After all, why would you hold something with a below-market rate if it didn’t give you some sort of liquidity benefit? This logic can be used to construct what’s called a Divisia monetary index, in which a variety of assets are weighted by their moneyness.

So let’s return to our skeptical wonk. Yes, the Quantity Theory broke down – but only when looking at M2, which was never an economically sensible aggregate (In fact, it was the deregulation of the 80s that opened the market for a variety of near-moneys that weren’t captured by M2, that led to M2’s fading usefulness). The much-problematized demand for money is actually quite stable if you look at a Divisia aggregate. And despite being broader, it even turns out to be a more feasible target for monetary policy than M2 was.


Ecological Monetarism and the New Quantity Theory

“Old” monetarism tended to take monetary aggregates like M0 and M2 at face value, and thus riddled with caveats, sunk beneath the stormy seas of Ceteris Non Paribus. If the demand for money isn’t stable, how much can we say in practice with the Quantity Theory?

By contrast, what I’ve called “ecological” monetarism – sensitive to the fact that money isn’t just a handful of very liquid assets thrown together into an aggregate, but a complex interplay of the plans of both money users and money providers – can dispense with many of the caveats and epicycles of Old Monetarism.

So how does an ecological Quantity Theory guide you through 2008 and 2021?

  • Deflation in 2008. Yes, the quantity of base money quintupled, but this was more than offset by a collapse in broader monies. Even though M2 was stable, Divisia M4 showed a decline in 2008 – exactly what would predict the deflation we saw.
  • Inflation following Covid. With newly printed money flooding the economy via stimulus checks but nowhere to spend it during lockdowns, the demand for money naturally spiked. But knowing the demand for money is stable, suggests a quantifiable gap between money supply and money demand that has to be closed by inflation as the economy recovers from Covid. This key assumption enabled a prediction of the timing of both the beginning and the end of the inflation.

The back-of-the-envelope model that predicted the beginning and the end of the post-Covid inflation.


So If you just know where to look, you can outperform everyone from DSGE-armed central bankers to Greedflationist journalists in predicting inflation. The path of our recent inflation and recovery should be understood as a huge practical win for the Quantity Theory – if you use the right quantity.


Cameron Harwick is a monetary economist and Assistant Professor at SUNY Brockport.