Economics: Inflation - The Pull Of Money

(Drivebycuriosity) - Fed chairman Jerome Powell declares that US inflation rates will stay high for a while and the Federal Reserve will need more interest rate hikes to fight it. 

I beg to differ.

I don`t talk about the price level. Yes, that will stay high. I talk about the inflation rate which is the change rate of the price level.

It might be helpful to recall Calculus. The inflation rate is the change of the price level: First Derivative. The change of the inflation rate is the Second Derivative. 

I assume that the price level will rise slower or even stop growing, which means falling inflation rates (the First Derivative is shrinking, the Second Derivative is negative).

Here`s why:

( fred.stlouisfed)

                    Helicopter Money Gone

The high inflation rate has been caused by a flood of money in the past. In 2020 & 2021 the US government flooded the economy with stimulus checks in the value of trillions of dollars (American Rescue Plan), supported by huge bond purchases by the Federal Reserve. 

The government money landed directly on the bank accounts of the Americans, blowing up the money volume M2 (bank notes & coins & deposits at banks). Milton Friedman described this as helicopter money (cato ).

Over two years the US money volume M2 jumped about 40% as a result (the charts by the Federal Reserve of St. Louis display a huge hunchback  fred.stlouisfed). The money deluge met a constraint supply of goods & services, partly because of Covid19. It is no surprise that prices had to increase so much (marginalrevolution).

But monetary growth had already peaked in February 2021 (with plus 27%). Since then the monetary growth rates have been falling and turned negative in December 2022.  

In the recent months the money volume has been shrinking! In May M2 dropped 4% YoY.  "We have never seen money taken out of the economy like this in our history" ( twitter.com).

 

                     Causal Connection

The causal connection between money and inflation is known since the 16th century at least. Nicolaus Copernicus described already in the year 1522 how "too much money" causes inflation. Copernicus` "quantity theory of money" is based on observations: 

The Spaniards had conquered today`s Latin America and looted the silver stocks. They send the precious metal to Europe where is was printed into coins and used as money. As a result the European money volume jumped, meeting a restrained supply of goods (agriculture, hand works) &  services. The flood of money raised suddenly the demand for scarce goods & services and caused a jump of the price level.

Elaborated studies by Milton Friedman, Karl Brunner, Allan Meltzer and many other economists (known as Monetarists) described already in the 1960s how and why the inflation rate follows the growth rate of money with a time lag (causal connection).

 

 

    The Pull Of The Shrinking Money Supply

Since the inflation rate (growth rate of prices) follows the growth of money with a lag, the inflation rate will continue to follow the pull of the shrinking money volume and the inflation rate will continue to drop.