Inflation, said the Nobel price winning economist Milton Friedman, is always and everywhere a monetary phenomenon. Put simply, what he meant is that the price level is a function of how much money is available to buy how many goods. It is what is known as the quantitative theory of money and can be simply expressed as:
V * M = P * T,
with V being the velocity of money, or how often a dollar bill is used, M being the money supply, or how many dollars are in circulation, P being the price level, measured by the consumer Price Index and T the total output of the economy, effectively GDP. Now P is rising. T was falling for a while as governments shut down the global economy, but is now growing modestly again – or at least not falling (yet). V has been falling, first as banks deleveraged after the financial crisis and lately as businesses and consumers hoarded cash, as witnesses by the saving rate going up. That leaves M. If the quantitative theory of money is right, the rise in P, or inflation, must be driven by a rise in M, the amount of money circulating in the economy. There are a number of ways of measuring M, but we can settle on M2, a measure that includes cash and on demand deposits. And M2 did indeed rise dramatically as governments pumped money into the economy to mitigate the effects of lockdown.
Inflation as a mainstream topic has been largely dead for decades, as the only question on economist’s minds was why there wasn’t any. Some commentators were pointing out that though consumer prices were not rising, asset price inflation was widespread, with equity markets, property and debt valuations going through the roof as central banks embarked on experimental monetary policies such as quantitative easing sand zero or even negative interest rates. Now, with consumer price inflation in double digits in many places, the blame is being put on supply chain bottlenecks in the aftermath of Covid lockdowns, the Ukraine war pushing up commodity prices and China’s zero Covid policies reversing the downward price pressure caused by decades of international supply chain integration, otherwise known as globalisation.
But if inflation is a monetary phenomenon, such factors can only cause temporary price rises, not a permanent shift upwards of the general price level. If what we are experiencing is actual inflation, it should be caused by an increase in the money supply, as we saw above. That leaves us with the question: why has the money supply increased.
When central banks resorted to quantitative easing (QE) in the aftermath of the Global Financial Crisis, they did so with the explicit goal of increasing liquidity and affecting interest rates in the longer end of the curve – they already control short term interest rates through the setting of their main overnight policy rate at which commercial banks lend out their reserves to each other. However, many economists have characterised QE as money printing, blaming the policy for directly increasing the money supply. But if this was true, why did consumer price inflation not rear its head until now?
First, it is important to realise that central banks are not in control of the money supply. Under a system of fractional reserve banking, commercial banks create new money by extending credit. When issuing a loan, the bank credits the current account of the lender, creating a liability on its balance sheet, and offsets it by booking the loan on the asset side. The bank has increased the amount of bank deposits in current accounts and as this is a part of M2 money supply, the bank has indeed created new money. Thus, it is by expanding its balance sheet that the commercial banking system impacts the money supply. Central banks can of course impact the demand for credit by setting short term interest rates, but only indirectly. The amount of credit determines the amount of money. Credit is money.
Back to Quantitative Easing; QE is the term used for the policy of the central bank purchasing assets (government and mortgage bonds) from the market and paying for it simply by increasing the amount of electronic ledger money (bank reserves) it keeps on its balance sheet. The seller of the bond will normally be a pension fund or another institutional investor. Such entities will not take the cash and spend it on goods and services. Rather, the funds will be reinvested into other assets such as other bonds or stocks. This is why some economists prefer to characterise QE as an asset swap. QE is injecting liquidity, not new money into the system. While this may seem an academic discussion, it holds the key to answering the question of why years of QE did not produce the CPI inflation so many economists warned it would. What took place was asset swaps. The central bank ended up buying up big chunks of the outstanding volume of government bonds, mortgage backed securities (MBS) and agency securities and the private sector used the funds it got in return to bid up the price of other assets classes; equities, corporate bonds, real estate, emerging market debt, etc. Yes, QE did cause price rises, but the transmission mechanism, where the bank reserves being created were effectively transferred to institutional investors who didn’t spend, but reinvested the money, kept the money within the financial system and out of the ‘secular’ economy. Until Covid hit…
Lockdowns changed the nature of QE. Firstly, the scale went up. Whereas QE 1, 2 and 3 conducted over the years 2008-14 totalled around USD 4tn, QE 4, the Covid programme, racked up another almost USD 6tn in the space of two years (roughly half in US Treasuries and the other half in MBS).
Second, the funding needs of the government and QE operations became more closely linked. Central banks became the backstop for public funding needs as governments took on unprecedented levels of debt. As such, QE began more directly to impact the total levels of credit (debt) in the economy. This also meant a subtle change in the QE mechanics. When the Fed essentially buys bonds directly from the Treasury, the electronic ledger money ends up not with institutional investors, but in the Treasury General Account, the government’s current account at the Fed. The money is then transferred into the ‘secular’ economy as the government purchases goods and services.
This is what happened as central banks embarked on massive QE programmes, ostensibly to provide liquidity but in reality in recognition of the fact that a locked down private sector would not be able to absorb the huge amount of new public debt about to be issued to fund the vast spending programmes politicians dreamed up to shield people from the devastating effects of lockdown.
It amounted to what can effectively be described as the monetisation of government debt and as the QE transmission mechanism directly impacted the money supply, inflation quickly followed – as predicted by the quantitative theory of money.
But what’s next? If QE did in fact work to increase the money supply, will Quantitative Tightening (QT), the reverse process where central banks reduce their balance sheets by selling off their bond holdings, reduce the money supply and reverse inflation, maybe even lead to deflation?
The end of QE will certainly put an end to any inflationary effects but QT will not lead to deflation. These days, government bonds that are not held by the central banks are almost exclusively owned by institutional investors such as pension funds and insurance companies, and as we know, when these entities are counterparty in QE transactions, QE effectively amounts to an asset swap. The reverse QT transaction will simply mean that the private sector will buy government bonds (with higher yields these are now more attractive investments) and sell other assets. That is bad news for asset markets but will not have material impact on the money supply.
That is the likely effect of QT: a broad-based negative for global asset markets. As opposed to QE, where central banks can effectively decide to monetise government debt issuance which will eventually put fresh cash in the hands of consumers, QT leaves them unable to control who buys the bonds. To reduce the money supply, the bonds would have to be purchased by entities who will forego consumption to finance the bond investment. As mentioned, that is highly unlikely as government bond investors are almost exclusively institutional.
The other instrument at the disposal of central banks, short term interest rate manipulation, can have an effect on inflation, but not in the way the central banks want you to believe. Central bank orthodoxy tells us that inflation can be kept in check if unemployment is kept at a long-term equilibrium, the NAIRU (Non-Acceleration Inflation Rate of Unemployment). This is the relationship captured in the Philips Curve (more here) and traditionally central bankers have used their policy rates to turn the economic temperature up and down to achieve this equilibrium. However, if the quantitative theory of money is right, unemployment as such is not a driver of inflation (though high unemployment means less production and hence fewer goods in the economy – and the same money chasing fewer goods means rising prices). Interest rates are still important as they influence the demand for credit – remember, credit is money – so central banks are not impotent. But since the money supply is not determined by central banks, but in the commercial banking system, what happens to inflation is beyond direct control of central bankers unless they directly monetise government debt.
So, Milton Friedman may have been right when he said that inflation is a monetary phenomenon. But our monetary system is not something that can be centrally planned. Central banks are not the all-powerful institutions they want you to believe, and most certainly far from the wise, steady hands who keeps the economy on even keel. But that is not to say that they are not influential. Through the last decade or more their unprecedented policies have blown up asset bubbles across the world and their decision to underwrite government debt issuance during the pandemic is in large part responsible for the inflation which is now undermining our standard of living. The history of central banks is more a story of the unintended consequences of their policies than of top economists cleverly managing the business cycle.