What Can We Believe in the Debate on Inflation?

An ordinary citizen can hardly be blamed if he or she is confused about what is causing inflation. Democrats have pointed to many other villains other than themselves for the causes of inflation. They have pointed to Putin’s war on Ukraine, to the COVID-19 pandemic stifling international commerce, and to private companies for price gouging. What can we believe in the debate on inflation?

Before we can search for inflation’s causes, we must know the meaning of the word “inflation.” We must have a rigorous definition of the word.

How to Define Inflation

Inflation is measured by comparing the present value of a dollar in terms of the goods and services it can buy with its value in some previous standard year, often taken as 2010 or 2015. In what follows we will use capital letters to represent nominal monetary values of the current year, and the same letter in lower case to represent the same quantity in the constant dollars of the standard year. Now suppose that for any particular year, the supply of money (usually taken as M2 money) in that year is M nominal dollars, and the nominal GDP for that year is Y. We can now define a quantity called the velocity of money V that is the average number of times any one dollar changes hands in transactions for goods and services. If that is the case, then MV is the total dollar value of all transactions in the economy for that year, which is the same as the GDP. We can now define a price index P, which compares the present year’s GDP in current dollars to the same GDP in the standard year’s dollars.

or

Now let x be any of these variables in the standard year’s values and X be its value in the current year. We now define a ∆ operator by

∆x ≡ X – x

It is fairly easy to show (see this PDF for details) that

What this equation says is that the inflation rate, i.e. the percent change in the price index, is equal to the percent change in money supply plus the percent change in the velocity of money minus the percent change in the GDP. To explain inflation we must be able to explain the changes in the money supply, in the velocity of money, and in the GDP.

Clearly, to reduce inflation, one must reduce the quantity of money circulating in the economy, reduce the velocity of money, or increase the rate of growth of the GDP. According to the St. Lewis Federal Reserve District Bank, the annualized percent change of M2 money supply was -1.8 % in the second quarter of 2022. The corresponding values for the percent changes of M2 money velocity and GDP growth are 2.5 % and -3.6 % respectively. This strongly suggests that the annualized Q3 inflation rate will be close to

100% X ∆P / P = -1.8% + 2.5% + 3.6% = 4.3%.

The big change causing the reduction in inflation is the decrease in the money supply. Will it last?

The Forces Driving Inflation

The history of the inflation rate throughout both the Trump and Biden administrations is shown below.

As you can see, although there has been a small reduction in the last month in the increase of average prices, they are still increasing at an annualized rate of 8.5%. Democrats would have us believe this represents a peak in inflation. But is this assertion true? The estimate of future inflation we made above at a rate of 4.3 % would seem to support the claim.

Yet, the declaration we have reached peak inflation is premature. The recent fall in inflation is due to a reduction in the money supply. We must consider the effects of the falling money supply on the GDP growth rate, which is currently negative and therefore inflationary. Remember the familiar trope that inflation is too many dollars chasing too few goods? Which will be greater: A reduction of the money supply, if that indeed continues, or the contraction of the GDP?

Depending on the Federal Reserve’s future monetary policy, the future could go one of two ways. First, the Federal Reserve could continue to reduce the money supply to strangle inflation. To do this, it would have to reduce the money supply enough to keep interest rates above the inflation rate. Then the costs of borrowing money would be greater than the money’s reduced worth. Such a policy would certainly eliminate inflation, but the reduction in lending would probably decrease economic activity enough to deepen the recession we are in. We would attempt to buy a reduction in inflation at the cost of a deepened recession. If the decline in the GDP is greater than the fall in the money supply, we could still have inflation. This is the very definition of stagflation.

Second, the Federal Reserve could attempt to encourage economic growth by increasing the money supply, i.e. by diminishing interest rates. If this does not stimulate growth enough to outweigh the increasing money supply, we would still have inflation. Since there are other economic forces, mostly caused by the Biden Administration, driving a deepening recession, such a Federal Reserve policy does not seem very promising.

It would seem the short-term possibilities are the following: (1) A reduction in inflation at the cost of a deepening recession, (2) a growing economy at the cost of accelerating inflation, or (3) increasing inflation with a deepening recession, i.e. stagflation.

The Velocity of Money

The one force driving inflation we have not discussed yet is the velocity of money. It is the usually forgotten inflation driver left out of the formulation that “inflation is too many dollars chasing too few goods.” The velocity of money is the average number of times a dollar changes hands in transactions over a year. An increasing money velocity increases the effective number of dollars chasing after goods and services, and therefore is inflationary. A decreasing velocity is deflationary. The annualized percent change in the velocity of M2 money from the beginning of the Trump Administration to the end of Q2 2022 is shown below.

During the Trump Administration, the velocity of money stayed relatively constant until the onset of the state-induced COVID-19 recession. After a rapid plunge, the annualized percent change slowly began to rise again. Under Biden, it rose more rapidly until it finally became positive again in the last quarter.

What determines the percent change in money velocity is the average expectations of the American people for future inflation. It is a matter of mass psychology. If most people expect little or no inflation, the percent change will fluctuate around zero. This is what happened for most of the Trump Administration until the COVID-19 pandemic shut the economy down. However, if most people expect high and accelerating inflation, they will rapidly try to buy what they need. They will try to get rid of their money as fast as possible while it still has value. This seems to be the kind of environment we are entering.

What Can We Expect?

The future does not look good for the American economy. Despite what Democrats would have us believe, we are now in a recession. The quarterly real GDP growth rate for Q1 2022 was -0.40 %, and for Q2 2022 it was -0.23 %. The annualized rates are four times these values or -1.60 % and -0.92 % respectively. The trend for real GDP growth is shown in the graph below.

The evolution of the Atlanta Federal Reserve’s GDPNow estimate for Q3 real GDP growth is shown below. The latest value of +1.8 % was published August 16, 2022. The values in the graph are seasonally adjusted annual rates.

Therefore, we might briefly come out of recession in the third quarter. However, a note accompanying this graph adds a warning.

The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2022 is 1.8 percent on August 16, down from 2.5 percent on August 10. After recent releases from the US Department of the Treasury’s Bureau of the Fiscal Service, the US Bureau of Labor Statistics, the US Census Bureau, and the Federal Reserve Board of Governors, a decrease in the nowcast of third-quarter real gross private domestic investment growth from 0.2 percent to -3.6 percent was slightly offset by an increase in the nowcast of third-quarter real government spending growth from 1.7 percent to 2.0 percent.

Federal Reserve Bank of Atlanta / GDPNow

The emphasis in this quote is mine. What the note tells us is the GDPNow model is depending on government spending to offset a reduction in investments by private companies. Yet, the Rahn Curve tells us that as the governments of developed countries’ increase their spending as a fraction of GDP, their economic growth falls.

Why all this matters is that if a recession becomes deep enough, it combined with an increasing velocity of money can overcome a Fed-induced reduction in money stock to create growing inflation. Also, take note of this nonlinear effect: To reduce inflation by taking money out of the system, the Federal Reserve would have to increase interest rates to be greater than the inflation rate. Forty years ago, the Chairman of the Federal Reserve Paul Volcker strangled the last great American inflation in this way. At the same time he strangled the GDP.

In addition, Democrats are doubling down on policies that constitute a war on the supply side of the economy. Such destructive policies should also push us toward hyperinflation. May God and the U.S. electorate save us!

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