Inflation?

Robert Eisenbeis, Ph.D.

Thu Aug 20, 2020

During an August 14, 2020, lecture at the Center for Financial Stability, Charles Goodhart (former member of the Bank of England’s Monetary Policy Committee and professor at the London School of Economics) mused about the US’s current economic slowdown and the prospects for inflation that might result because of the extraordinary increase in the money supply that has occurred (http://centerforfinancialstability.org/research/Goodhart_Deflation_Inflation_081420.pdf).

After reviewing history, Goodhart turns to a discussion of where we are now. He makes three points. First, policy is currently expansionary, with low interest rates. Second, the pandemic has resulted in a shock to both aggregate demand and supply, and the path of the recovery is as yet uncertain and critically dependent upon a vaccine. Third, inflation will remain low for a long time. However, he then notes Milton Friedman’s classic observation that “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” (Milton Friedman, “The Counter-Revolution in Monetary Theory,” IEA Occasional Paper No. 33, 1970; https://miltonfriedman.hoover.org/friedman_images/Collections/2016c21/IEA_1970.pdf.

Goodhart notes that monetary growth has surged by some 32% in early 2020, and to a monetary economist this means that future inflation is almost a certainty. The timing is uncertain and depends on what happens to the velocity of circulation. As the chart below shows, the decline in velocity in the short run has offset the money supply increase, due in part to a large increase in precautionary saving and a drastic cut in aggregate demand for many goods and services.

To Friedman, this was a natural response encoded in Irving Fisher’s equation MV=PT (money times velocity equals prices times the volume of transactions). In current terms the increase in money has largely been offset by a decrease in the volume of transactions, with little impact on prices. However, Friedman notes that during inflationary periods with rapid expansion of demand, velocity tends to increase in lockstep with the money supply. We would note, too, that we have not seen such a sharp drop in velocity nor such a sharp rise in the money supply since WWII. Both factors represent ominous prospects for monetarists.

Goodhart then speculates as to what policy options might be available should the economy recover and policy need to be changed to prevent the inflation that many economists fear is inevitable. He suggests that options that involve increases in interest rates, either directly by tightening policy or by letting central bank balance sheets run off. Both of these options, he argues, are fraught with political constraints, either to keep the costs of debt financing down or to avoid the increase in debt levels that will put further pressure on debt markets.

Not mentioned in Goodhart’s paper is the issue of how high interest rates might have to go to dampen inflationary pressure – which is likely to be high due to the sheer volume of reserves that have been put into the system – if the Federal Reserve insists upon using only its current interest-rate policy tools and open-market operations. The alternative in the short term, as we have argued previously, is to use reserve requirements to temporarily sterilize the ability of the banking system to expand credit and the private-sector money supply to meet the growth in demand that will accompany an expansion. Using reserve requirements and differential interest rates on required and excess reserves would reduce the extent that interest rates would have to be increased to address inflationary pressure, because it would involve working on the margins rather than on the total volume of outstanding credit. For example, with high reserve requirements, a higher rate on excess reserves than on required reserves would tend to discourage too rapid expansion and not involve the radical movements in interest rates that a pure interest rate policy would require.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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