If Friedman Is Right, Inflation Could Plummet!
- By Julius Probst, PhD
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- 7 min read
Excessive money growth during the height of the pandemic was a good predictor for high inflation one year later.
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Summary
- Excessive money growth during the height of the pandemic was a good predictor for high inflation one year later.
- Money growth is plunging now, which could indicate the path of inflation and suggest an economic slowdown is likely soon.
- Central bankers misjudged the path of the recovery by focusing on unemployment gaps instead of monetary forces. In the process, they generated a boom-bust cycle, exactly what Milton Friedman would have warned us about.
Introduction
Last year inflation surged to the highest level since the 1970s, with advanced economies experiencing YoY rates approaching or exceeding 10%.
Even acknowledging all the unexpected supply shocks from the Ukraine war, central banks have evidently misjudged the strength of the pandemic recovery and current inflation dynamics. For example, the Bank of England (BoE) still believed in 2021 that inflation would be around 3% in 2022; it actually peaked at just over 10% (Chart 1).
And other central banks got it wrong too. The big question is why. But a bigger one is what happens next? In this piece, I argue a faulty framework is causing many to misjudge current inflation dynamics. Friedman would argue that the previous money-fueled inflationary boom was misguided and that the current plunge in money growth is a mistake in the other direction since it increases the probability of a larger-than-expected recession.
Misjudging the Path of the Recovery
Most neo-Keynesian macroeconomic models rely on the Phillips curve, which describes the relationship between the unemployment (or output) gap and inflation. Unfortunately, this relationship is dubious, at best. The slope of the Phillips curve depends on many factors, including the macroeconomic regime and the central bank’s reaction function.
Before the pandemic, that slope was extremely flat, meaning that closing the output gap did not translate into higher prices.
During the pandemic, economists also mistakenly extrapolated macroeconomic trends from the Great Recession, which preceded almost a decade of stagnation. The financial crisis led to a huge asset price crash and deleveraging cycle. Credit and asset price busts are historically followed by lackluster recoveries.
The pandemic shock was very different, though. Primarily, the monetary and fiscal policy response was far larger – this was the only recession ever in which household disposable income surged. Between 2020 and 2021, US consumers accumulated an estimated $2-2.5 trillion in excess savings, some 10% of GDP.
This excess first showed up in asset prices and is now showing up in excess nominal spending. The Mercatus nominal GDP gap shows the economy‘s nominal GDP path is almost 6% above trend (Chart 3). That is an enormous amount of overheating!
So a large amount of US inflation is demand driven, a result of excessive nominal spending.
Could economists have predicted this? Perhaps, if they had used Friedman’s plucking model. It offers a more realistic assessment of current business cycle dynamics. Unlike neo-Keynesian models, it suggests the business cycle is asymmetric. Instead, the economy is regularly pulled below trend during recessions – and the larger the downward pull, the larger the subsequent recovery.
Given that the pandemic prompted neither a credit bust nor deleveraging cycle, economists should have expected the swift recovery that followed since private sector balance sheets remained strong.
Some Unpleasant Monetarist Arithmetic
The second lesson that economists need to re-learn is that money matters. Most modern macro models do not include monetary aggregates but are based on interest rate targeting rules instead. But problematically, the gap between the actual and natural rate is what matters for the monetary policy stance – only the natural rate is unobservable.
Instead of basing monetary policy on unobservable variables like the natural interest rate, the natural rate of unemployment and potential output (r*, u*, and y*), central bankers might want to focus on monetary and credit aggregates as well as nominal expenditures.
The equation of exchange states the relationship between money supply (M), money velocity (V), the price level (P), and real output (Y):
M*V = P*Y
Rephrasing this in terms of growth rates, the inflation rate is a function of money growth, changes in velocity, and real GDP growth:
Inflation therefore equals the money growth rate, plus changes in velocity, minus real output growth. Money velocity can only be estimated indirectly. While it plunged originally during the pandemic, it has remained rather stable over the last few quarters (Chart 4).
Real output growth originally surged during the recovery but is now quickly losing momentum. So a substantial part of the remaining inflation comes from money growth.
Historically, economists have found, in the words of Friedman, that monetary policy acts with ‘long and various lags’.
Money of zero maturity (MZM) is the broadest measure of money that also includes institutional money market funds. The peak correlation between money growth and inflation is at about 18 months, meaning money leads prices by about 1.5 years. This estimate is similar to many empirical studies.
Given MZM surged over 30% within two years, we could have expected demand-side inflation. When pushed 18 months forward, money growth correlates strongly with inflation (Chart 6). As the chart shows, the huge increase in the MZM growth rate preceded the rise in inflation.
The good news is that money growth has finally slowed tremendously. But this is also the bad news. Just as money growth was excessive in 2021, it has now turned negative for the first time in decades. The US reached peak CPI last year, and the growth momentum is now turning, with the global economy heading towards a broad-based slowdown.
2022 Inflationary Boom Increases Odds of Hard Landing Now
The remaining question is why there was no similar surge in inflation after the financial crisis. Back in 2008, the Fed also expanded its balance sheet and engaged in various asset purchase programs (quantitative easing), but to no avail. Inflation remained low and below the Fed’s target for more than a decade.
There are three key differences between 2008 and the pandemic:
First, the financial crisis was followed by a huge asset and credit burst together with overleveraged private sector balance sheets. As asset prices plunged, households had to deleverage and cut back their spending, which led to large deflationary pressures post 2008. But in 2020 and 2021, asset prices surged, and household wealth increased significantly.
Second, the fiscal stimulus response was different. After 2009, fiscal policy turned contractionary whereas this time households received massive fiscal transfers that boosted their incomes during the pandemic.
Third, interest rates after 2008 remained stuck at zero for several years (the liquidity trap). Monetary policy loses traction at zero interest rates, and central banks’ balance sheet expansion has no immediate effect on broader monetary aggregates and nominal GDP, which is precisely why the inflationary effect is muted.
In 2020/2021, on the other hand, massive monetary stimulus was combined with stimulus checks for households. The combination of QE and cash transfers were exactly what Friedman had in mind when he first discussed the idea of helicopter money and how Japan could escape the liquidity trap.
And it worked like a charm for the US economy. Low interest rates only lasted for two years, and the Fed hiked its policy rate aggressively throughout 2022 to curb inflation. The fiscal and monetary response had a much more significant impact this time precisely because they led to a large boost in the money stock and nominal GDP.
However, as of this year, MZM is contracting significantly for the first time at a pace similar to the Volcker shock of the early 1980s when the Fed dramatically tightened monetary policy to contain inflation. And real money growth is contracting at about 12% YoY.
Inflationary pressures have been subsiding quickly this year, and the Fed’s tightening cycle is now hitting financial conditions.
The recent bank failures in the US (Silicon Valley Bank, Signature Bank, and First Republic Bank) led to contagion in financial markets in mid-March, with many other bank stocks taking the heat and Treasury yields plunging. Investors also went long on Bunds and the Japanese Yen, a classic flight into havens.
While the US economy does not appear to be at risk of a financial crisis soon, financial conditions have undoubtedly tightened significantly since end-2022. This is also affecting nominal spending in the economy. A large financial shock combined with the contraction in broader monetary aggregates would undo the Fed’s desired soft landing.
Conclusion
While the global negative supply shocks over the last two years have undoubtedly contributed to US inflation, US nominal spending has been substantially above trend for more than two years. A significant part of the inflation is thus demand-driven and due to the combined monetary and fiscal expansion.
The helicopter drop of money in 2020 is exactly what Friedman would have advocated to get us out of the slump, and it worked like a charm. However, monetary tightening should probably have come sooner, which I think is why the Fed had to step on the brakes so hard at the end of 2022.
With a bit of luck, monetary policymakers can lower nominal spending without creating too much excess unemployment. Much will depend on financial fragility, though – whether the financial sector can withstand interest rates close to 5%.