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.

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Guest's picture
Camden Spiller

The monetary increases of yesteryear were Children's Tylenol compared to the elephant tranquilizer dose the Administration is giving us now.

Government interference in the free market system is like any artificial drug treatment in an otherwise organic system... sometimes a little, at the right time, in the right dose, is a good thing. But it's very easy to overdose - and even easier to get addicted.

Guest's picture

Thanks for a great article, it always helps to get some educated perspective on what's being reported.

Guest's picture

The Fed buying treasuries and mortgage debt to the tune of trillions will be the spark that ignites an inflationary event of the century. Inflation is currency driven and the government's printing presses are running red-hot.

When the Fed liquified the system for Y2K, it wasn't comparable in scale, not close. They were able to quickly drain the liquidity away in any case.

No matter what the geniuses say, the 'masters-of-the-universe, those wizards behind the curtain say - their options are limited. They are buying more than a trillion dollars worth of debt, monetizing debt. The only way they could drain that debt is to sell the the treasuries and mortgage-backed securities back to the market. The government still will sell 2 trillion dollars worth of treasuries and the Fed would need to sell 1 trillion.

What would happen? Interest rates would spike sky high and economic recovery would be a faraway dream.

This is what happens when government meddles. Too bad the public are soundly asleep. They should be in the streets protesting before they're in the streets because they're homeless!

Guest's picture

Wouldn't it be great if the government would start releasing the M3 money supply number again? Isn't it amazing they stopped posting in 2005? While core inflation is not spiking, non-core, food and energy have been spiking over the last 8 years. Given that oil has been denominated in dollars for many years, you don't see a correlation with money being dumped in the market over the last 8 years and a corresponding rise in oil prices?

Do people realize what oil is used for? It isn't just gas. It's fertilizer, plastic, paint, carpet and other synthetics. It is in everything! I hope everyone is prepared for 4 and 5 dollar gas as it will happen within a year.

Guest's picture

"they drained the excess reserves"

You're making the assumption that there is the political will to deflate (credit drops, unemployment increases).

I very much doubt that.

Inflation even at 1970s levels is preferable to politicians who want to get re-elected.

So we might get back to 5% unemployment, but see 30 year mortgage rates of 15%.

Philip Brewer's picture

It's true that a happy outcome from the current situation is unlikely.  In fact, I've written a post on what I see as the most likely outcome--an extreme version of the stagflation of the 1970s:  Stag-hyperinflation.

The thing is, though, it is possible to come out of this situation reasonably okay--and, in fact, the Fed hasn't screwed up too badly so far.  Even as inflation rates were soaring a year ago, the Fed correctly forecast that the recession and the financial panic posed a greater threat of deflation, and moved to counter that--and so far successfully.  But now comes the tricky part--escaping without producing a hyperinflation.  It's possible (although it will probably result in a double-dip recession), but screwing up will mean the worst of all possible worlds.

Guest's picture

Interesting observations, but...

The magnitude of the change in the monetary base this year is off the charts at over 110%. How can you reasonably correlate CPI-inflation-to-monetary-base changes in the mid-1980s when that change was in the range of only 10% to 15%?

I don't think you reasonably can.

And Chris is right. The M3 indicator is the real key to predicting inflationary pressures -- not M2.

The fact is inflation is a friend to all debtors and the current administration's own budget projects an additional $10-TRILLION in debt being racked up by 2015. The only politically viable solution, short of taxing everybody into oblivion, is a tacit devaluation of the dollar via inflation. The Obama Administration understands this, as does the Fed.

You can deny it all you want, but inflation is coming -- and, as I've been preaching on my blog, you better prepare for it.

My $0.02 (after taxes -- and inflation)

Len Penzo dot Com

Guest's picture

The outcome you expect from all this insanity depends on whether or not you trust in the pinheads at the FED. And whether you believe they have the smarts to pull of the biggest magic trick ever.

I do not trust or believe in them.

Just buy gold and protect your family.

Guest's picture

As long as bank physical assets are not questioned or required for debt settlement, the problem will be pushed down the road.
As the government allows bank assets to re-inflate through the continuation of speculation... derivative swaps and leveraged trading in commodities (for instance), the bubble will grow again.
As banks buy distressed assets at bargain prices, and as long as the federal government guarantees these purchases, there will be no spikes.
How long can this continue?
Probably another year. Then hyper inflation, or devaluation. Same thing.
As long as money rules, government is impotent.
Suspicion is that government is complicit.

Philip Brewer's picture

@ Kelja:

I'm not sure it's a matter of trust.  I'm confident that the people at the Fed know how to stop an inflation--Volker provided a solid example in the early 1980s.  What I'm doubtful about is not their ability, it's their guts.  It takes more than most Fed governers have to put the country through a tough recession just to grind out inflation--and it'll be all the tougher after we've just been through the worst recession since the Great Depression.

There are a couple of reasons that I'm optimistic, though. 

One is that we're only one generation away from people who saw what inflation rates over 10% do to the economy.  In the 1950s and 1960s it was easy to imagine that one more percentage point of inflation wouldn't be as bad as one more percentage point of unemployment.  But the 1970s showed us that all making that tradeoff gave us was inflation and unemployment.  I don't think it's been so long that policy-makers will have forgotten that lesson.

The other is that inflation is really tough on people who have money.  (It's tough on other people too--people with fixed incomes, for example--but it's most particularly tough on people with money.)  People with money, though, tend to have influence in the government.  Many other groups lack political power; if there's an economic situation that's tough for people who are (as a few examples) broke or have a private pension or make their living fishing, it's tough for them to bring much influence to bear--they're too few and too disorganized and just generally lacking in influence.  People with money, though, tend to have influence.  If there an economic situation that hurts them--such as a high inflation rate--they have the political power to get things fixed.

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