As inflation rises, the currency dog ​​is having its day

Inflation is always and everywhere a monetary phenomenon”. Milton Friedman made this remark in 1963. At the time, very few macroeconomists agreed with him. Twenty years later, a high percentage did. Twenty years later, again most have not. Today, nearly two decades from now, economists must take money seriously. If money is ignored, it will take revenge. Like Bridgewater’s Ray Dalio was recently asked: “Where is the historical and common sense understanding of the quantity of money, credit, and the quantity of inflation?”

Year-to-date growth line graph in Divsia M4, including Treasury (%) shows the big jump in US money during the pandemic is exceptional

Opinion that there is a link between money supply and inflation is very old. When people are holding more money than they want, they want to get rid of it. As with any other asset, this will lower its price. But the nominal price of money is fixed: a dollar is a dollar. The adjustment takes place through higher prices for everything else – or inflation.

After an exceptional currency expansion in 2020, we are certainly seeing this. I noted the possibility in That May. Tim Congdon, a famous monetarist, argued this before me. According to Financial Stability Center, “Divisia M4” (an index that measures components by their roles in a transaction) grew 30% in the year to July 2020, almost three times faster than any similar period since 1967. None of that happened after the 2008 financial crisis. Many people then worry about expanding the monetary base. But that doesn’t matter because it doesn’t affect broader sets. (See chart.)

Broad Money Growth line chart (M3,% year-on-year change) shows that the US broad money supply grew especially fast in 2020

A great lesson of history is that if economists think they understand how the macroeconomy works, they are wrong. In the 1930s, it was common sense that the economy was stabilizing itself. In the 1960s, inflation expectations and money didn’t matter. In the 1980s, only money mattered. In the 2000s, credit expansion would not destabilize the financial system. In 2020, money is no longer relevant. Again and again, we love stories of innocence. We like to believe that the economy is a simple mechanism, but it is not.

Width of money (M3) line graph as % of nominal GDP shows that Pandemic has brought about huge leaps in money-to-GDP ratio

In 1975, the British economist Charles Goodhart argued that “any observable statistical statistic will tend to collapse once pressure is placed on it for the sake of control”. His insight was applied to the failure of monetarists to run the economy. But Friedman wouldn’t be surprised. He had Discuss that amount hit the economy with a “latency that is both long and variable.” But he doesn’t believe in driving the economy. Those who have turned to inflation targeting instead.

However, “Goodhart’s law” has a logical consequence: once a measure is no longer the goal, it becomes meaningful again. As Mervyn King, former governor of the Bank of England, noted in a recent featured lectures: “Money has disappeared from modern inflation models.” It’s ridiculous. So why did this happen? That’s because technocrats have a stupid tendency to prefer exact wrong over right.

So where are we today? Optimists argue that the inflation we are seeing is just the result of temporary shortages caused by the pandemic. That’s really part of the story, like a IMF’s recent article explain. However, the requirement, it asserted, is to “maintain the incomplete recovery and ensure that output catches up with pre-pandemic trends – without allowing wages and prices to rise”. Indeed. The difficulty is, as Robin Brooks of the Institute of International Finance has pointed out, inflation is pervasive: in the US, the share of the index’s index of commodities experienced a price increase of more than 2% in the year to January. in 2022 is only 90 percent lower. To make things worse, Alex Domash and Lawrence Summers argue that measures showing a very tight U.S. labor market, such as hiring and exit rates, are better indicators of inflationary pressures than being out of work. Worse still, the tightening of today’s labor market may have previously been linked to an unemployment rate below 2%.

In a nutshell, the inflation genie is out of the ordinary, especially in the US. The danger is that this creates a spiral in which inflation expectations shift upward, causing a shift away from the currency and thus further destabilizing expectations. There is no reason to say this will not happen, because it can clearly happen when inflation is much higher than the target and previous forecasts. Credibility will have to be preserved, whatever is necessary.

General line chart Inflation: the proportion (%) of items in the basket with annual inflation above 2% shows that the full-year inflation is not limited to a few items

What this means in policy is now hard enough. But as King strongly argues, central bankers must also rethink some of their recent doctrine. Just as the financial crisis showed banking problems, so this rising inflation shows money is important. It also turns out that forward instruction assumes more knowledge than anyone possesses. Central banks can explain their response function, but cannot say what they will do, because they do not know what the economy will do. Last but not least, the average inflation target certainly remains latent. It never makes sense to target future inflation based on past mistakes. Does the US Federal Reserve really intend to reduce inflation below 2% to make up for the prolonged spike? What it means is to reaffirm your determination to achieve your goals towards the future. But it’s also possible that we’ll see a degree of financial uncertainty that will force thinking deeper into the matter.

General line chart Inflation: the proportion (%) of items in the basket with annual inflation above 2% * shows that monthly inflation is also quite general across economies

We should always remember that we know very little about the economy. Central banks must be humble and prudent. They can’t ignore valuable information just because they don’t like what it presents. Yes, we cannot run the economy through the money supply. But we cannot ignore it either. It carries warnings.

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