Oh noes! Inflation!
The Wall Street Journal has an opinion piece by Arthur Laffer that shows a scary graph of the monetary base, which has surged enormously in the past year. He suggests that this is "potentially far more inflationary" than the monetary policies of the 1970s. I'm as worried about inflation as anybody, and agree that the Fed should already be taking steps to minimize it, but I think Laffer is off-base here.
Here's a graph much like the one in the Wall Street Journal opinion piece, showing the recent spike in the monetary base. You can see a couple of earlier, much smaller spikes when the Fed took action in advance of Y2K and after 9/11. Scary, no?
Except, here's a view of changes in the monetary base from 1984 to mid-2008 (i.e. until the recent spike), together with CPI inflation over the same period. Notice a strong correlation between changes in the monetary base and future inflation? No? Me neither.
Okay, here's another. This is the M2 money supply versus CPI inflation from 1984 through mid-2008. To my eye, that at least shows some correlation--the money supply rises before inflation heats up and then drops when inflation drops. The correlation doesn't look so hot from 1995 through 2005, but we are starting to get a better picture of what happened then--the excessive money supply growth pumped up asset prices (the dotcom bubble), while globalization held down consumer prices.
So, what does that tell us? Maybe not a lot. But, if M2 money supply is of at least some use for prediction future inflation, here's another look--the same graph, but this time running up to the latest data available. The CPI rate has plummeted--the year-over-year change in prices actually going negative due to the combination of falling fuel prices, the financial collapse, and the recession. But look at M2--the rate of change there is hardly unprecedented. We saw similar spikes in the mid-1980s and then again when the Fed eased monetary policy in the wake of the dotcom crash. That is liable to lead to some inflation, but it's an ordinary risk of an ordinary rate of inflation--not some huge hyperinflationary catastrophe.
Now, I don't want to minimize the dangers of the surge in the monetary base. If that potential for money creation is realized as actual growth in the money supply, then we can kiss the dollar good-bye. But although the surge is unprecedented in its magnitude, there's actually a good example of the Fed managing a monetary-base spike without producing a catastrophe--the results of their actions in the run-up to Y2K.
Concerned that the Y2K bug might take down the computers that ran the ATMs, the banks, and the communications networks that connected the banks, the Fed made sure that there was extra cash in the hands of the banks and extra reserves in the banking system, just in case. Then, when it turned out that nearly everyone had fixed all their important Y2K bugs, they drained the excess reserves. Here's a close-up of the monetary base and CPI during that period, showing no sign of wild swings in prices. That's not proof that we won't have a huge inflationary spike, but it does show that it's at least possible to have large swings in monetary base growth without adverse impact on prices.
I'm worried about inflation too; I just don't think the scary monetary base graph is the reason to be scared.