July 9, 2021 Reading Time: 9 minutes

Johnny Lee’s apt warning in his hit song “Lookin’ For Love In All The Wrong Places” suggests you cannot find what you seek unless you know what you are looking for and look in the right place. The same might be said about “inflation.” It turns out that too many people are looking for the wrong response to the relentless expansions of money and credit overseen by the Federal Reserve. 

In the wake of the ongoing (never ending?) implementation of “unconventional” policies (e.g., ZIRP, NIRP, QE, LSAP, etc), most monetary aggregates have soared to previously unimaginable heights. In turn, those schooled in or influenced by Monetarism, especially if guided by the seminal works of Milton Friedman, are looking for “inflation” as measured as rising price levels as indicated by indices like the CPI or PCE. 

It may be worthwhile to make a point concerning what is meant by “inflation.” Among Classical Economists, inflation was the act of creating excessive rates of growth of the circulating medium at the time. In practical terms, an inflated money supply leading to disequilibrium was depicted as a cause of economic instability. 

However, the success of Monetarists during the second half of the 20th century, especially in explaining the “stagflation” during the 1970s, led its usage to describe an effect of monetary expansions. This is seen by examining the “equation of exchange” used to support the Modern Quantity Theory of Money.  

While the equation of exchange appears in various forms, we will use the following: 

MV = Py; 

M is money supply growth,  

V is velocity of circulation (the inverse of the demand for cash balances), 

P is the price level (e.g., CPI or PCE), 

y is a measure of output (e.g., GDP) 

A simple interpretation of the Quantity Theory is that when V is stable due to institutional or historical influences and total output (y) is fixed, changes in M will lead to equally proportionate changes in P. This logical sequence supported Friedman’s famous maxim that “inflation is everywhere and always a monetary phenomenon” whereby price levels (“inflation”) rise if the growth rate of monetary aggregates exceeds that of national income. (NB: among Classical Economists this would have been a tautological, even banal statement given that inflating the money supply was a cause, not an effect.) 

For its part, adherence to the conclusions of Monetarists played a key role in ending persistent increases in price levels (“inflation”) seen in many industrialized economies and “hyper-inflation” in less-developed economies during the late 20th century. In turn, this model is now being applied to guide nearly all central banks and is at least partially responsible for their justifications to introduce and adhere to “unconventional” monetary policies. 

Indeed, while Chairman of the Board of Governors for the Federal Reserve System, Ben Bernanke channeled Milton Friedman in making a promise to engage in a “helicopter drop” of dollars if necessary to slay deflation. There is considerable irony in invoking the champion of monetary policy restraint as a cover for the introduction of “unconventional” monetary policies (e.g., ZIRP, QE, LSAP, etc). Alas, Professor Friedman is not available for comments. 

Now, if we follow Monetarist logic, it is easy to see why so many people express concerns about an impending spike in price levels (“inflation”). As it is, the FED has engaged in unprecedented interventions into financial markets, pushing up the “asset” side of its balance sheet from $870 billion in 2007 to $4.5 trillion in 2015. Since then, they have nearly doubled to $8 trillion. 

In light of the expectations from the Quantity Theory of Money, the sort of increases in base money and narrow measures of money supply without significant rises in price levels (“inflation”) is truly a conundrum. We seem to be in a situation summarized by Winston Churchill in the late 1930s in reflecting that Russia (USSR) “ … is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key.”   

I suggest that the key to this puzzle is found in part in the policies of the FED, particularly the payment of interest on reserves held by commercial banks. The offer of risk-free placement, despite low returns, “sterilizes” the injections and keeps them out of the lending stream. As such, increases in M are offset by decreases in V so that the tautological equilibrium in the Equation of Exchange remains intact. 

Another partial explanation might be seen in considering what was happening before the housing and financial crash of 2008-09. Prior to that “crisis,” there were also large increases in monetary aggregates without an accompanying rise in price levels (“inflation”). The solution seems to be that the impacts went into expansion of the trade deficit and the bubble in housing that were not captured by either the CPI or PCE. 

In all events, a broader picture of these questions requires the original use of “inflation” as understood by Classical Economists when economic theory involved investigating human actions, i.e., microeconomics or price theory. From that perspective, rising price levels (“inflation”) will be seen as only one possible result of an inflated money supply that, like water, will find its way into various entry points.  

 As we shall see, failure to realize that there is no single channel of entry and no single impact arising from an inflated money supply. Otherwise, not only will we be lookin’ in the wrong place(s), we might be lookin’ for the wrong thing(s). 

Returning to the water analogy allows one to see how injections of newly-created circulating medium might flow into an economy. The important determinants of the eventual impacts arise from who receives the inflow, when it reaches them; and then, how or when they decide to spend it; if at all, given that most or all could go into savings.  

Since markets involve the interactions of individuals or firms with different perceptions, expectations, values, etc., it is naïve to imagine proportional outcomes. Of course, these differences will cause relative prices to change before price levels (“inflation”) change by a perceptible amount. 

The next step in deciphering the impacts on an inflated money supply on an economy is to create some artificial distinctions or delineations of economic activities. First, there is the real sector where manufacturing or exchanges of goods and services take place. Next, there is the financial sector where banking transactions occur or where shares and bonds or other such instruments are traded. Then we can delineate activities that occur on the domestic side while others involve cross-border or international transactions. 

Among domestic impacts of an inflated money supply on the real sector is increased personal consumption that changes relative prices, leading to rising price levels (“inflation”). But this requires the excess liquidity or newly-created credit finding its way into the pockets of consumers. (NB: this is the focus of those looking for “inflation.”) 

Another point of entry can be seen in the domestic labor and capital markets in the form of rising wages and salaries. This can occur if artificially cheap credit allows producers to expand production capacity by hiring more labor even without encouragement from consumers. Instead, or in addition, these firms might use cheapened credit to buy capital goods or commodities to mix with the existing labor force.   

Other domestic impacts of excess liquidity and cheap credit can be seen as increased purchases of real estate or housing or fine art and antiques or “nonfungible tokens” and cryptocurrencies that are fetching enormous sums. For the most part, many channels of entry of an inflated money supply into the domestic, real sector do not contribute to higher price levels (“inflation”) when measured as changes in consumer price indices (CPI or PCE). 

Turning to the domestic financial sector, the availability of artificially-low interest rates can lead to increased bank deposits or purchases of shares or bonds. Indeed, the value of both stocks and bonds has risen to the point where they are almost certainly unsustainable, with an increasing likelihood that they will deflate considerably in the not-so-distant future.  

Finally, open capital markets will allow some of the excess liquidity to leak out of the economy through the purchase of foreign currencies or international financial or real assets. These outflows will tend to cause the domestic currency to depreciate and put pressure on international accounts. 

As such, it is surprising there is so much (only?) interest in what happens to domestic price levels (“inflation”) when old bubbles have come and gone or new bubbles are forming in a wide range of assets. By focusing myopically on the implications drawn from their (Monetarist) model, central bankers will point to muted CPI or PCE as evidence of the efficacy of their unconventional policies.  

While claiming innocence about bubbles and other distortions reverberating through the economy, central bankers have introduced distortions and instability that someday must be resolved through market corrections. Part of the reason that their analysis has gone wrong is part of a larger problem in economics, per se, in that mainstream macroeconomic theory has eschewed the microeconomic orientation of Classical Economics.  

Instead of investigating economic processes as the outcome of human interactions, there has been a shift towards macroeconomic concepts and measurements. These involve a high level of abstraction away from individual behavior toward attempting to estimate aggregate outcomes that may not be susceptible to measurement. 

Consider that the bubble in bond markets is most troubling as the valuation of accumulated private and public-sector debt has been driven off the charts. While the total debt of the US is more than $80 trillion, according to the Institute of International Finance, total global debt was $289 trillion at the end of the 1st quarter of 2021.  

As such, bond market valuations dwarf stock market capitalization. (US exchanges account for about 56% of the total global capitalizations worth about $90 trillion.) In terms of sheer numbers, a sharp downward correction in bond valuations, perhaps from an unexpected spike in interest rates, would have a more devastating effect on financial markets than a correction in share pricing. 

It is bad enough that economies are struggling to shake off the devastation imposed upon them by ill-considered pandemic policies. Alas, an existential threat to global economic stability is in play due to ill-considered monetary policies. While public health policies were justified based on good intentions or settled science, central bankers justify their policy choices on well-established, if faulty, monetary theory. 

It is probably clear to anyone not receiving a paycheck from the FED that there is no clear exit path for their ongoing policies of historically-low interest rates set and influenced by unconventional monetary policies. 

As it is, there cannot be a pain-free exit with the unknown downside risks from “toxic” assets hiding in the balance sheets of central banks. Given the unique closeness of the relationship between the FED and the Treasury, the likely future course of balance sheet repair will involve shifting one form of paper debt in exchange for different types of paper debt. (NB: all dollars under a fiat currency regime constitute a form of non-extinguishable debt.)

For the moment, central banks are being able to maintain their policy course, even though there is widespread disquiet about how it will all end.  

It turns out that central bankers can continue their dubious policies because they are acting in tandem, not necessarily from direct consultations or explicit agreement, but they are generally following the same model.  

In the past, if a single country engaged in outsized rates of growth of their money supply or suppressed interest rates to cheapen access to credit, international adjustment mechanisms would bring them back in line. Being out of sync with monetary policies of other countries often led to a falling international exchange value of their circulating medium or capital outflows, both contributing to economic stagnation. But now, nearly all central banks are on the same page, doing what would have been considered inappropriate or untenable under the conventional wisdom of monetary policies of yore. 

I often think back on my graduate courses during the 1970s. Had I suggested that near-zero or negative nominal interest rates were sensible for an industrialized economy, I am certain my monetary theory professor would have written me off as a joker or a fool. Worse, he might have summoned the campus cops to escort me out of class, perhaps into a mental institution. 

There is some clarity as to where we are with respect to central bank policy, but there is great uncertainty about where it all leads as is shown by the worries about future increases in price levels (“inflation”). I would offer a more likely, and more ominous set of outcomes. 

Consider the possibility that creditors will eventually be oversaturated with debt and refuse to take on any more without an increase in yields. As yields rise, the inverse relationship between bond prices and interest rates will spark several reactions.  

Businesses seeking to roll over debts at lower rates will find it harder to cover their borrowing costs as rates rise. Bondholders, seeing rates rising and fearing capital losses as the market price of the bonds they hold diminish, will begin to sell. If sellers significantly exceed buyers, there will be a cascading effect so that central banks will lose the false impression that they can control interest rates against market impulses.  

Governments, households and businesses that continue to seek debt financing will find the burden of covering the interest cost of their old and new debt will rise. As they are forced to curb their spending, there will be a slump in economic activity and rising unemployment. Note that all of this could occur without rising price levels (“inflation”).  

It turns out that all of this could have been avoided had monetary policy makers not been so wedded to their faulty models that led to their myopia about how to measure the effectiveness of their policies. The sad part of the tale is that the messenger of bad tidings, i.e., market processes, will be blamed for the disasters caused by central bankers. 

Unfortunately, the abstractions and fixation on aggregates of mainstream macroeconomic and monetary theory, being opposite sides of the same coin, led to less attention being paid to dynamic impacts on the microeconomy that arise from inflating the circulating medium. So, it seems that not only are some people lookin’ in the wrong place; they are lookin’ for the wrong thing.  

In the end, the concern over the potential for increased future price levels (“inflation” as measured by CPI or PCE) is largely misplaced. It may not be the most serious or most likely outcome of the ongoing “unconventional” policies that have been inflating the circulating medium. 

Christopher Lingle

Christopher Lingle

Christopher Lingle is a Visiting Senior Fellow at AIER, Visiting Professor of Economics in the Escuela de Negocios at Universidad Francisco Marroquín in Guatemala, Research Scholar at the Centre for Civil Society (New Delhi), International Political Economic Advisor for the Asian Institute for Diplomacy and International Affairs (AIDIA – Kathmandu), International Senior Fellow at the Property Rights Institute (USA), Senior Fellow at the Center for Market Education (Malaysia), & Senior Visiting Fellow, Advocata (Colombo, Sri Lanka).

His research interests are in the areas of Political Economy and International Economics with a focus on emerging market economies and public policy reform in East and Central Europe, East Asia, Latin America, and Southern Africa.

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