The experience of the last five years has clearly demonstrated that an expansion in the monetary base doesn’t necessarily lead to an immediate rise in the price level. While the Federal Reserve has increased the monetary base in the United States by roughly five-fold over the past five years, inflation has remained subdued.
However, does this mean that inflation will be contained if the monetary base remains at these high levels? Furthermore, does the experience of the last five years imply that the long-term relationship between money and inflation is dead?
In each case, the answer is “no”.
Many financial market commentators seem to believe that the long-term relationship between base money and the price level is “broken”. Indeed, the prevailing view seems to be that the level of the monetary base is irrelevant to inflation, provided that the economy does not “overheat”.
The view that “money doesn’t matter” flies in the face of what is arguably the strongest empirical relationship in macroeconomics. While economists like to pontificate about the importance of the “output gap” in the determination of inflation, the fact is that the empirical evidence supporting the relationship between the output gap and inflation is weak and statistically tenuous.
John Hussman, a fund manager and economist, discusses the absence of evidence for the output gap/inflation relationship at length in his post “Will the Real Phillips Curve Please Stand Up?” Similarly, Professor John Cochrane discusses the non-existent relationship between the output gap and inflation in his excellent article “Inflation and Debt”.
In contrast, dozens of academic studies have repeatedly demonstrated a strong and statistically important long-term relationship between the monetary base and the price level. While it is a well-recognised fact that the relationship between money and inflation is weak in the short term, the long-term relationship between money and inflation is a core empirical observation described in every serious economics textbook.
If the long-term relationship between money creation and inflation is not broken, then this raises an obvious question: when will inflation in the United States “catch up” with the expansion in the monetary base? However, in order to have any hope at answering that question, we need to answer a more general question.
Why does inflation tend to lag money creation?
In order to understand why inflation tends to lag increases in the monetary base, we need to explore two fundamental concepts:
- The price level depends upon the value of money, and
- The value of money depends upon confidence.
We will explore each of these ideas in more detail in a moment, but first, let’s explain how these ideas can be used to explain the delay between monetary base expansion and inflation.
The value of money is the denominator of every “money price” in the economy. All else remaining equal, as the market value of money falls, the prices of goods and services, as measured in money terms, will rise.
When a central bank prints more money, it may or may not have an immediate effect on the value of money. The reason for this is that the value of money depends upon a series of long-term expectations regarding the future of the economy and the future of the monetary base (or, more technically, the expected future path of the “real output/base money” ratio).
If markets believe that the increase in the monetary base is “temporary”, then such an increase may have little impact on the value of money. Furthermore, if markets believe that the actions taken by the central bank will increase the long-term growth rate of the economy, then such actions may even lead to an increase in the value of money. In other words, if the central banks actions are perceived to be temporary and these actions boost confidence in the economy, then printing money may have a slightly deflationary effect, at least in the short term.
However, what happens if expectations shift? What happens if markets start to realize that the “temporary” expansion in the monetary base is actually a “permanent” expansion in the monetary base? The value of money will begin to fall and, all else equal, the price level will begin to rise. Such a fall in the value of money can be quickly compounded if, simultaneously, the market becomes more pessimistic about the long-term economic prospects of society.
Currently, investors are very optimistic about the future of the US economy and seem to believe that the Federal Reserve is “on track” to reduce the monetary base over the next 5-10 years. This perception has supported the value of the US Dollar, which in turn, has been one of the major factors suppressing prices in the US.
But what happens if market confidence starts to slip? It is easy to imagine a scenario one year from now, where the US economy begins to weaken and markets start to doubt the ability or willingness of the Federal Reserve to significantly reduce the monetary base. If this does occur, then the value of money (the value of the USD) will begin fall, maybe gradually at first, but then more precipitously. As it does, inflation will begin to rise. While global deflationary forces may continue to put pressure upon the market value of goods/services, a significant decline in the market value of money can easily overwhelm this phenomenon, leading to a significant rise in prices.
Let’s step away from the US for the moment and think about what might happen in a small, less advanced economy that engages in money printing. The act of printing money tends to create an immediate boost in economic activity and an immediate boost in confidence (regardless of how that new money is spent). The simple fact is that as newly created money is flushed through the economy, jobs are created and people feel better about the economy and the world around them. Sometimes, this effect is so powerful that people believe that the economy will continue to grow strongly even as all this extra money is gradually retired at some point in the future. Consequently, the value of money is supported and the inflation is contained.
However, as historical experience has taught us, printing money rarely has any lasting effect on the growth of the economy. After a few years pass, people in our small, less advanced economy begin to realize that growth really isn’t that good (all the old problems remain) and that the economy is only being sustained at its current levels by the sustained creation of money. In other words, the economy has become addicted to the money-printing drug.
Inevitably, this collapse in confidence leads to a collapse in the market value of money. The exchange rate collapses and prices, in local currency terms, surge higher.
Inflation lags money printing because expectations can take a long time to change. The value of a long-duration asset (money) depends upon long-term expectations and it can take many years for changes in long-term expectations to occur.
Does this same principle apply to advanced economies? Absolutely.
The price level depends upon the value of money, and the value of money depends upon long-term expectations. Printing money may not have an immediate impact on the value of money because it does not have an immediate impact on long-term expectations. Rather, it may take several years before the markets begin to lose faith in the grand plans of policy-makers. But when the market does lose faith, the value of money can erode rapidly and prices can rise swiftly, even at time when real economic activity is falling.
For those readers that are interested, let’s briefly explore this argument in more technical terms. We have glossed over two important ideas that deserve further consideration.
The first idea is that the price level depends upon the market value of money.
More specifically, the market value of money is the denominator of every “money price” in the economy: as the market value of money falls, the price level, as measured in money terms, rises.
In order to understand this concept, it helps to think about the determination of prices in a barter economy. Let’s assume we have a two-good economy that produces only apples and bananas. What determines the price of apples in banana terms? Is it the market value of apples as determined by supply and demand for apples, or is it the market value of bananas as determined by supply and demand for bananas?
The answer is “both”. The price of apples in banana terms depends upon the market value of the primary good (apples) and the market value of the measurement good (bananas). All else equal, as the market value of the measurement good (bananas) falls, the price of apples, as measured in banana terms, will rise.
Economics struggles with this concept because it fails to recognize that the property of “market value” can and should be measured in the absolute. Every price is a relative expression of two market values. We can measure the market value of each item being exchange in absolute terms and plot supply and demand for each good in absolute terms. This somewhat abstract concept is explained in great detail in The Inflation Enigma, the second presentation in The Enigma Series.
Just as the price of apples in banana terms depends upon both the market value of apples and the market value of bananas, so the price of apples in money terms depends upon the market value of apples and the market value of money. If the market value of money falls, then the price of apples, in money terms will rise.
We can extend this microeconomic theory of price determination to a macroeconomic level. If the market value of money falls, then, all else remaining equal, the price of all goods and services in the economy will rise. This is the “Ratio Theory of the Price Level” as developed in The Enigma Series.
The second leg of our argument, namely “the value of money depends upon confidence”, requires a much more technical discussion. There isn’t time in this post to cover all the elements of this second leg of the argument. However, we can briefly touch on the key ideas.
The view of The Money Enigma is that money is a special-form equity instrument. Fiat money derives its value from the liability that it represents. More specifically, money is a long-duration, proportional claim on the output of society.
The easiest way to think about this is to compare money to shares in a corporation. A corporation can issue fixed or variable entitlements against the future economic benefits it creates (future cash flows). Similarly, society can issue fixed or variable entitlements against its future output.
Money represents a variable entitlement to the future output of society. If the markets believe that there will be a lot more claims issued in the future, then the value of each of those claims will fall. Conversely, if people believe that economic growth will be stronger in the future, then the value of each of those claims will rise.
Critically, fiat money is a long-duration asset. The value of fiat money depends primarily upon expectations regarding the long-term future growth rate of base money relative to real output.
Changes in the current level of the monetary base are largely irrelevant to the value of money. What really matters are expectations regarding the level of the monetary base in 20-30 years and, similarly, the expected growth in real output over that extended period.
Therefore, in the short term, it is possible to dramatically expand the monetary base with little impact on the value of money. The value of fiat money depends on long-term expectations of the “real output/base money” ratio. If market participants believe that an expansion in the monetary base is only temporary, then it should have little impact on the value of money.
The notion that fiat money represents a proportional claim on the future output of society is discussed at length in The Money Enigma, the first paper in The Enigma Series. Those readers who are interested in a more technical discussion of the long-duration nature of money should read The Velocity Enigma, the final paper in The Enigma Series.