(Bloomberg Opinion) — “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
It was in a lecture delivered in London in 1970 that Milton Friedman uttered those famous words, the credo of monetarism.
Over the previous five years, inflation in most countries had been on the rise. In the first half of the 1960s, U.S. consumer prices had never gone up by more than 2% in any 12-month period. The average inflation rate from January 1960 until December 1965 had been just 1.3%. But thereafter it moved upward in two jumps, reaching 3.8% in October 1966 and 6.4% in February 1970.
For Friedman, this had been the more or less inevitable consequence of allowing the money supply to grow too rapidly. The monetary aggregate known as M2 (cash in public hands, plus checking and savings accounts, as well as money market funds) grew at an average annual rate of 7% throughout the 1960s. Moreover, as Friedman pointed out in his lecture, the velocity of circulation had not moved in the opposite direction.
What no one knew in 1970, though Friedman certainly suspected it, was that much worse lay ahead. By the end of 1974, U.S. consumer prices were rising at more than 12% a year. The “great inflation” of the 1970s (which was only really great by North American standards) peaked in early 1980 at 14%. Friedman’s London audience had an even rougher ride in store for them. U.K. annual inflation hit 23% in 1975. That year, as an 11-year-old schoolboy, I wrote a letter to the Glasgow Herald (my first ever publication) that bemoaned the price of shoes, because I could see my mother’s sticker shock each time I needed a new pair. Prices were rising significantly faster than my feet were growing — and that was saying something.
In recent weeks, investors have been acting in ways that suggest they fear a repeat of at least the first part of that history — the 1960s, if not the 1970s. On Thursday, Federal Reserve Chair Jerome Powell made the latest of multiple attempts by Fed officials to reassure markets that they have nothing to fear from a temporary bout of higher inflation as the U.S. economy emerges from the Covid-19 pandemic. In response, you could almost hear the chants of “always and everywhere a monetary phenomenon.” After all, the latest M2 growth rate (for January) is 25.8% — roughly twice the rate at inflation’s peaks in the 1970s. (Yes, I know velocity is way down.)
The crucial indicator in this debate is inflation expectations. These can be measured in various ways, but one of the best is the so-called breakeven inflation rate, which is derived from five-year Treasury securities and five-year Treasury inflation-indexed Securities, and tells us what market participants expect inflation to be on average in the next five years. Less than a year ago, that expected inflation rate was down to 0.14%. Last Wednesday it was at 2.45%. The last time it was that high was in April 2011.
Another indicator of market anxiety is the steepening of the yield curve (though that could well be capturing growth expectations as well as inflation fears). In the shock of the pandemic, the yield on 10-year Treasuries fell as low as 0.6%. Now it is up to 1.56%. Because the yields of government bonds with shorter maturities have not moved up so much, the widening spread can be seen as a further sign that markets expect inflation.
To some observers, including Fed economists, all this seems like market overreaction. The Fed’s preferred measures of inflation, derived from the price indices of personal consumer expenditures, have consistently undershot the 2% inflation target for most of the period since the global financial crisis. In only 10 months out of the 149 since Lehman Brothers Inc. went bust has core PCE (excluding the volatile costs of energy and food) exceeded 2%. The latest reading is 1.5%. Indeed, average core inflation has been 1.9% for the past 30 years — since the presidency of George H. W. Bush. In any case, the economy is only just emerging from one of the biggest supply shocks in economic history — the lockdowns and other “non-pharmaceutical interventions” to which we resorted to limit the spread of the SARS-CoV-2.
Looking at the past three decades, you can see why the Fed subscribes to what might be called the Mad Magazine view of inflation: “What, me worry?” Last month, Powell said, “Frankly we welcome slightly higher … inflation. The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time.”
Since last September, the Fed has pledged to keep its Fed funds rate at near zero and its bond purchases (quantitative easing) going until the labor market has made “significant progress” in recovering from the Covid shock. In very similar speeches last week, Fed Governor Lael Brainard and Mary Daly, president of the San Francisco Fed, reiterated this commitment. It’s not just that they don’t worry about inflation above 2%. They actively want inflation above 2% because they are now targeting an average rate of 2%.
In making this argument, the Fed folks are telling us that post-pandemic inflation will be so fleeting as to leave expectations essentially unchanged. “A burst of transitory inflation,” in Brainard’s words, “seems more probable than a durable shift above target in the inflation trend and an unmooring of inflation expectations to the upside.” Those who worry about such an unmooring, argued Daly, are succumbing to “the tug of fear … a memory of high and rising inflation, an inexorable link between unemployment, wages and prices, and a Federal Reserve that once fell behind the policy curve. But the world today is different, and we can’t let those memories, those scars, dictate current and future policy … That was more than three decades ago, and times have changed.”
Now, I plead guilty to having worried about inflation prematurely in the past, something for which I was vehemently (and unfairly) criticized by Paul Krugman and others. Eleven years later, I am not about to repeat that mistake. Yes, the administration of President Donald Trump ran the economy hot with big tax cuts and browbeat the Fed to abandon its planned normalization of monetary policy — and even at 3.5% unemployment, inflation barely moved. Yes, as Skanda Amarnath and Alex Williams very reasonably argue, the reopening of services such as bars and restaurants will likely push up PCE inflation, but not by much and only temporarily. Only if inflation is sustained and accompanied by equally sustained wage inflation would the Fed need to change its stance.
Yet this entire debate has been turned on its head by the intervention of former Treasury secretary and Harvard University President Lawrence Summers. Back in 2014, it was Summers who resurrected the idea of “secular stagnation,” predicting (correctly, as it proved) that the period after the global financial crisis would be characterized by sluggish economic performance and very low interest rates. There was therefore some consternation in the world of economics when Summers published a stinging critique of President Joe Biden’s proposed $1.9 trillion fiscal stimulus on Feb. 4.
“There is a chance,” warned Summers, “that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability.”
At this point, we need to make our first qualification of Friedman’s monetarist credo. Actually, inflation is often and in many places a fiscal phenomenon — or at least, you don’t get inflation without a combination of fiscal and monetary expansion. Summers’s point is that the proposed fiscal stimulus is far larger than the likely output gap, insofar as that can be estimated. Even before the additional stimulus, Summers wrote, “unemployment is falling, rather than skyrocketing as it was in 2009, and the economy is likely before too long to receive a major boost as Covid-19 comes under control. … Monetary conditions are [also] far looser today than in 2009. … There is likely to be further strengthening of demand as consumers spend down the approximately $1.5 trillion they accumulated last year.”
Although economists working for the Biden administration and Democratic Party operatives shot back, Summers’s argument was endorsed by other big hitters, notably Olivier Blanchard, only recently a proponent of active fiscal policy. Martin Wolf, a rampant Keynesian in the period after the financial crisis, called the stimulus plan “a risky experiment.”
Even investors who don’t share my respect for these academic economists could hear a version of the same argument from two of the great financial market players. “Bonds are not the place to be these days,” wrote Warren Buffett in the latest Berkshire Hathaway report. “My overriding theme is inflation relative to what the policymakers think,” Stan Druckenmiller said in an interview. “Basically the play is inflation. I have a short Treasury position, primarily at the long end.”
Time for a further amendment to Friedman’s credo. Like the equation that encapsulates the quantity theory of money (MV=PQ), the assertion that inflation is always a monetary phenomenon verges on being a tautology. In truth, monetary expansions, like the fiscal deficits with which they are often associated, are the result of policy decisions, which are rooted in decision-makers’ mental models, which originate in some combination of experience and study of history. The Fed folks are telling us that inflation expectations will stay anchored, even if inflation jumps above 2% for a time. The big beasts of economics and investment may just have longer…