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Some Commentary On Inflation

inflationprinting-moneyAn often asked question goes something like this: “How is it possible for the Fed to expand the money supply without inflation showing up?” There are two answers to this question.

  1. One pertains to the real rate of inflation versus the reported rate of inflation. Government continues to manipulate and change CPI calculations in ways to diminish the reported amount of inflation. This manipulation is not accidental. It serves two purposes. It enables government to keep the populace less unhappy by claiming inflation is lower than it really is and artificially inflating real GDP. Secondly, it helps reduce government spending with respect to any programs tied to cost-of-living increases. Social Security is the big one. Some have claimed that Social Security payments would be double what they currently are if the CPI were calculated honestly. To the extent that is true, the government deliberately cheats the elderly. It also collects higher taxes by driving up nominal gains when there are no real gains, especially on capital assets.’s website is devoted to statistically adjusting for government chicanery to produce the real numbers. 
  2.  The second reason has to do with some rather unusual circumstances that exist today. The condition that offsets some of the effects of monetary expansion is likely temporary. This circumstance is discussed below:

Money Supply and Money Demand

The relationship between the monetary base and velocity determines the effect of money in the economy. The Federal Reserve controls the monetary base by injecting or withdrawing liquidity from the system. The chart below shows the massive increase in the monetary base.

monetary base02 (1)


Velocity is a measure of how rapidly money turns over in the economy. The Fed has limited control over velocity. The first chart represents the Supply of Money while velocity is a measure of the Demand for Money. Velocity is plummeting, which means people, businesses and banks are choosing to hold more money. That is, the demand for money can be thought of as increasing. Larger cash balances held means less money turns over in form of spending. Velocity is shown in this chart.


Both these charts are unprecedented. The Fed is pumping like crazy. The increases in supply are being mostly offset by the decreases in velocity. Let money, proportionately is being spent and more held (or hoarded if you prefer). There are valid reasons for velocity dropping. Two reasons are important:

  • Defensive Protection — The more uncertainty and fear in the economy, the more economic actors will expand their liquidity. More cash and cash equivalents are held under such circumstances.
  • Shortage of Liquidity and Solvency in the Banking System — Many banks are wary of customer defaults on loans in these economic difficulties. Further many assets on bank books are overstated and eventually will be written down. The government has encouraged banks to carry these assets at overstated values in order to hide the full extent of the liquidity and solvency problem in the banking system. At some point this policy will revert to reality and many banks fear being short reserves necessary to cover these losses. Hence they carry unusually large excess reserves in anticipation of this event. 

The first chart suggests we should have massive inflation as a result of the Federal Reserve policies. The second chart goes a long ways to explaining why we haven’t, at least not yet.

The Fed has two major problems on its hands. Neither is controllable. The first is that they have no way of reducing the money supply without causing a recession/depression. The second is that they have virtually no control over velocity. At some point velocity is going to begin to rise again and return to more normal levels. At that point, money begins to turnover faster. Then, more money is competing for the same amount of goods, which means prices will rise. That is when inflation, likely serious inflation, appears.

When prices begin to rise, rational behavior would push velocity up even faster. That is, once people recognize that prices are rising, to the extent they can they will advance purchases. They will buy in advance of anticipated future price increases. This phenomenon increases the rate at which prices rise, effectively leaving the Fed helpless. Ludwig von Mises referred to this phenomenon as the “crack-up boom.” This boom precedes and causes the economic collapse.

7 thoughts on “Some Commentary On Inflation”

  1. Pingback: Why do we want the federal reserve to have discretion on inflation? Has CPI been the right policy tool since the early 1980s? | macroeconomicvolatility

  2. Monty, the big omission in your analysis is debt. Central bank balance sheet expansion transmits into inflation by causing others in the economy to leverage up. But the end of that game comes when everyone is already leveraged to the max. At that point, the central banks can print to their hearts’ content, without generating an explosion of inflation, simply because very few can take on more debt, and there is very little good collateral left that isn’t already leveraged to the max.
    In this latest round, most of the new debt has been in the government sector (and student loans, but those are basically government too, aren’t they). But most governments are near or past any sane level of leverage on their projected tax receipts. And even the Fed is starting to realize that they can’t expand their balance sheet to infinity. We may get inflation down the line, but not until after the deflationary collapse of the debt house of cards.

  3. “How is it possible for the Fed to expand the money supply without inflation showing up?”
    It’s called Modern Money Theory” (MMT). Google: Warren Mosler, L. Randall Wray, Stephanie Kelton, Mike Norman to learn more.
    These so-called economic experts are either lying or ignorant when it comes to economic issues. Many appear to be afflicted with “confirmation bias” – they reject information that does not support their beliefs, and only seek out information which seemingly confirms how they think that the economic system functions. Also, economics and politics don’t mix – their understanding and proposed solutions are clouded by their politics, left or right, which is often incorrect.

  4. Why couldn’t the Fed do again what it did in ’79-’80 under Volker? Raise interest rates rapidly and intentionally put the economy in a slump. Under President Reagan inflation came down quickly. Admittedly, Obama is no Reagan.

    1. The Fed could do so and something like that would be the proper economic policy (Paul Krugman and other Keynesians notwithstanding). There are two problems with doing so today: 1) The economy would go into a very deep slump (depression); and 2) The government would be exposed as bankrupt. The Fed is enabling the government to behave in its irresponsible manner. The deficits cannot be funded without the Fed. Government spending would have to be reduced by a trillion dollars per year to regain credibility and maintain a budget that could be funded. That is the crux of the political problem that no one in Washington is willing to face.

      Markets will eventually force similar action on the government. When and how that happens is difficult to forecast. Suffice to say that it will be later (something the politicians consider a good thing) and more painful (something the politicians also know but choose to ignore for the continued appearance of normality).

      1. Monty, thanx for your thoughtful reply. I think the “crack-up boom” is farther away than you probably do. My prediction is that with the sequester, end of the payroll tax cut, various increases on high earners, and ObamaCare taxes, the deficit for ’13 will be around $800 billion, with it falling to around $600-700 bn for ’14. A deficit of $500 bn would be managable for a long time. Of course another major foreign expedition or domestic terrorist attack would alter this significantly. We’ll see if I’m right.

        1. Arthur, in what way is 500 Billion more in debt each year sustainable. Our illegal income tax is now barely servicing the interest on the debt.
          Interest compounding is a problem with your ideas.
          Write off all debt and revert back to only Gold and Silver. Hang all of our Lobby taking politicians.

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