Yesterday I listened to an interview with Jerome Powell, the Chairman of the Federal Reserve Board of Governors in which he asserted that since the 2008 financial crisis the rate of inflation is no longer linked to the money supply. Mr. Powell is very smart, and knows a lot more about monetary policy than I ever will, but that assertion is nonetheless absurd.
The traditional economic definition of “inflation” is an increase in the money supply. That is why in the 1970s economist Milton Friedman could assure us that inflation is “always and everywhere a monetary phenomenon.” The only way Mr. Powell’s assertion could be true is if he has adopted a different definition of “inflation” than that traditionally used by economists. In a 1949 novel, author, George Orwell, coined the term, “newspeak,” to describe officials changing the meaning of words to mislead or manipulate. I do not accuse Mr. Powell of trying to mislead or manipulate; he may have simply adopted newspeak already in common use.
Historically, inflation has led to general price increases, but inflation is not the only factor that affects prices. Mr. Powell may have been trying to say that non monetary factors have been major determinants of general prices since 2008. The one factor he mentioned was the pandemic of 2020 and 2021. The pandemic affected both supply and demand, so probably was a major factor during those years, and is likely still having some effect on prices in 2022. It is interesting, however, that general price levels began to increase rapidly right after Congress and the Federal Reserve worked together to dramatically increase the money supply, which is exactly what one would expect based on history and traditional economic theory. (Many other countries also intentionally inflated their money supplies in response to the pandemic, but few as severely as the U. S.)
Mr. Powell may also have been saying that the Federal Reserve’s attempts to control price levels by manipulating the money supply have been less effective since 2008. The Federal Reserve does not have total control over the money supply. Banks can multiply the money supply by lending based on deposits. The Fed regulates, but does not totally control banks in the U. S., and has essentially no control over foreign banks that hold dollars. Foreign currency that has its value pegged to the dollar can substitute for dollars, effectively increasing the worldwide dollar-based money supply. Borrowers other than banks can issue dollar-denominated bonds that may trade in lieu of cash.
And an increase in money supply (inflation) does not necessarily lead to higher prices. If the economy (meaning the quantity of goods and services available) grows, and the money supply grows at about the same rate, prices may remain stable. There also are issues related to velocity of money, such as how quickly people and businesses spend or deposit the money they receive.
Non-monetary government actions affecting prices, such as wars, trade restrictions, taxes, regulations, subsidies, etc. can reduce the costs of certain items, but inevitably reduce overall availability of consumer goods and services, and cause real general price levels to increase. Consumer confidence or uncertainty can temporarily affect demand, which affects prices. Business uncertainty can have similar effects on supply.
So, in summary, inflation is still directly linked to the money supply, but is just one of many factors that affect consumer prices. While other factors have certainly contributed to the recent increase in consumer prices, monetary inflation remains an important factor, perhaps the most important.
Posted 2022/10/26