Economics: Why Is Inflation So Stubbornly High?

  (Drivebycuriosity) - The inflation numbers are disappointing. The swift drop from the peak of 9.1% ended summer 2023, since then the numbers are fluctuating above 3% (cnbc ). There are several explanations for the sticky inflation. Since December 2023 the price of oil price climbed about 20%, lifting the gasoline prices on US pumps and so the costs for many products & services.

But Inflation less food & energy - the so-called core-inflation - also stays elevated. The numbers are partly magnified by the "shelter costs", a mix of rents & house prices, which count for about 40% of the core-inflation and 27% of the headline inflation! Unfortunately the statisticians base their calculations on rent payments from the past, therefore the "shelter" component has a time lag of 12-18 months! (marketwatch aier  cato). The actual reported inflation numbers are a view into the rear window.

 

 

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But there is a more important explanation. The image above shows the growth of the money supply M2 in the recent years, the main reason of the actual inflation.

In 2020 & 2021 the US government flooded the economy with stimulus checks in the value of trillions of dollars (American Rescue Plan), supported by massive 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 ).

As a result in 2020 & 2021 the US money supply M2, the engine of the inflation, jumped 40%. The money deluge met a constrained supply of goods & services partly - because of Covid19. "Inflation is caused by too much money chasing too few goods and services", noticed the economists at fisherinvestments. "

 

                     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: 

Early in the 16th century Spain conquered today`s Latin America and looted the silver stocks. The Spaniards send the precious metal to Europe where is was printed into coins and used as money.

As a result the European money supply 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).

Fortunately the monetary growth 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 supply has been shrinking! In February M2 dropped 1.7% YoY ( ycharts).

 

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Unfortunately the money flood from 2021/22 is not yet digested. As the image above shows there is still a surplus above the long term trend. This surplus works like hot steam in a boiler, keeping the inflation engine still running.

 

But the slow down of the money growth (image above) since summer 2022 is taking the pressure out of the inflationary steam boiler - albeit slowly - and inflation rates will drop again in the run of this year.