by Dr. Daniel Thornton, D.L. Thornton Economics
I have had a couple of responses to my impending-inflation-disaster essay suggesting that I’m the “boy who cried wolf.” They note that I (here) and others have been concerned about the potential inflation effects of the Fed’s QE policy for some time. But there’s been little smoke and no fire.
I am aware of the fact that the empirical relationship between money and inflation has been essentially nonexistent since the early 1980s. Indeed, early last year I argued (here) that neither the Phillips curve theory nor the monetary theory of inflation has credible empirical support.
Nevertheless, I am inclined to be concerned about inflation when money is growing abnormally fast; especially, when the rapid growth is the consequence of central bank monetary policy. The reason is the theoretical link between money and inflation is strong. Specifically, the price level is the price of goods and services in terms of money, so there is a direct link between money and prices.
According to the Phillips curve theory, inflation is related to the output gap (the gap between actual and potential output). The theory is based on the idea that there is a limit to how much an economy can produce or how fast an economy can grow. Hence, prices would rise whenever people tried to purchase more output than the economy could provide. Whether such limits exist and what they would be is an interesting metaphysical investigation.
Economists have no idea what these limits are or how to measure them.
But, they try. No matter how potential output is estimated it turns out to be little more than a trend measure of real output. Hence, when output goes substantially above its previous trend for a period of time, as it did during the period 1995-2007 (see Figure 2 above), estimates of potential are ratcheted up. Because output has been significantly below estimates of potential since 2007, estimates of potential have been ratcheted down annually (see Larry Summers, Figure 1 below).
This doesn’t bother true believers.
The Phillip curve theory is nearly always wrong about inflation, but it’s never wrong! It’s a tautology. If the output gap is small and inflation accelerates, believers say “this proves the Phillip curve theory.” If the output gap is small and inflation decelerates, believes say, “the output gap is bigger than we thought.” With this kind of logic, you can never be wrong!
So here is the bottom line of this essay. I don’t know if the massive increase in M1 will ultimately result in an inflation disaster, that’s why the titled of the essay had a question mark. The relationship between M1 and inflation since the early 1980s suggests it won’t. Nevertheless, I believe it is reasonable to sound the alarm because:
- There is a direct theoretical link between central bank created money and prices
- The increase in M1 that has occurred is unprecedented, and
- M1 will continue to grow rapidly so long as the Fed’s balance sheet remains large.
This is a Hedgeye Guest Contributor research note written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.