CHAPTER 15

Inflation

Inflation is always and everywhere a monetary phenomenon.

Milton Friedman, 1970¹

Milton Friedman once famously said, “Inflation is always and everywhere a monetary phenomenon.” But that is not true. The history of inflation in the United States over the past century demonstrates that inflation is not always a monetary phenomenon. Prices move higher and lower for non-monetary reasons, as well.

This chapter compares money supply growth and the inflation rate during each decade from the 1920s to the present. The evidence is clear: demand shocks and supply shocks have played at least as important a role as changes in the money supply in determining the rate of inflation. In fact, the link between money supply growth and inflation has become significantly weaker since the early 1980s; and, since 2008, money supply growth has had no impact on inflation whatsoever. Another factor – globalization – determines the inflation rate now. This has important implications for government policy.

A Century of Inflation

Over the past century, three factors have impacted the rate of inflation in the United States: the money supply, demand shocks and supply shocks. Increases in the money supply have led to inflation and decreases in the money supply have led to deflation. Similarly, there have been inflationary and deflationary demand shocks and inflationary and deflationary supply shocks.

The charts that follow – one for each decade – compare the annual rate of change for base money with the inflation rate. Base money is currency in circulation plus Bank Reserves, i.e., the deposits that banks hold in their reserve accounts at the Fed. This is the money that the Fed creates. The inflation rate used is Consumer Price Index: All Items (CPI). (Please note that all references to inflation, the inflation rate and money supply growth refer to the percentage change relative to one year earlier, unless otherwise stated.)

1919 to 1929

The first period covers the years 1919 to 1929.² That decade was remarkable in that it witnessed the highest rates of inflation and deflation during the century covered in this chapter. It also saw the century's sharpest contraction in the money supply. World War I was responsible for these wide swings in prices and the money supply.

Wars cause inflation. Government demand for war materials pushes prices higher; and central bank financing of government debt through money creation pushes prices higher. World War I ended in November 1918. Inflation peaked a year and a half later in June 1920 with prices 24% higher than one year earlier. See Chart 15.1.

By January 1921, prices had begun to fall. Exactly 12 months after the highest rate of inflation the United States was to experience during the twentieth century, the country suffered the worst deflation of the century. In June 1921, the annual rate of consumer price inflation was negative 16%.

CHART 15.1 Base Money vs. CPI: Percentage Change from Year Ago, 1919 to 1929

Source: Data from the Federal Reserve Bank of St. Louis³

During the twentieth century, the Depression of 1921 was second only to the Great Depression of the 1930s in terms of severity. When the war ended, the government stopped buying war materials, so prices fell. Moreover, as described in Chapter 3, when the war ended, the Fed's balance sheet contracted sharply as the bills it had discounted to help finance the war were repaid. As the Fed's assets shrank, so did its liabilities. Currency in circulation, one of the two principal components of the money supply, contracted from $3.6 billion at the end of 1920 to $2.3 billion in March 1922. Consequently, base money contracted. At its trough in October 1921, it was down 16%. The contraction of the money supply compounded the blow to the economy that resulted from the end of government expenditure on the war.

A great deal can be learned about inflation from the economic boom and bust that accompanied and followed World War I. The very high rates of inflation during 1919 and 1920 had two causes. The first was an inflationary demand shock related to government spending during the war. The second cause was the expansion of the money supply as the Fed discounted bills in order to allow the government to finance its war expenditures at low interest rates.

The severe deflation of 1921 and 1922 also had two causes. The first was a deflationary demand shock when the government curtailed its spending at the end of the war. The second was the record setting contraction of the money supply when the Fed's assets and liabilities shrank. As will be seen shortly, even though the United States involvement in World War II was much longer and much more expensive than its involvement in World War I, the inflation rate was lower during World War II as the result of government-imposed price controls, while deflation was avoided after the war due to better central bank management of the money supply.

By 1923, the economy had recovered and the Roaring Twenties were soon underway. This period was remarkable in two important respects. Consumer financing became available for the first time on a very large scale. Households were able to buy automobiles and home appliances on monthly installment plans. Home mortgages also became much more widely used. Rapidly increasing consumer debt is one reason the Depression of 1921 was so short-lived.

CHART 15.2 US Government Debt, 1900 to 1930

Source: United States Department of the Treasury

It is also noteworthy that the US government paid down its debt during this decade. Government debt peaked at $27 billion in 1919 and was reduced to $16 billion by 1930, as shown in Chart 15.2.

Just as large-scale government borrowing pushes up interest rates and “crowds out” the private sector by deterring private sector borrowing and investment, a large reduction in government debt tends to push interest rates down and therefore encourages private sector borrowing and investment. Moreover, the reduction in the amount of government bonds outstanding forced investors to invest elsewhere. This helps explain the extraordinary stock market boom of the late 1920s. With fewer government bonds to buy, investors were “crowded in” to the stock market. This pattern recurred 80 years later. The NASDAQ bubble formed when the government ran budget surpluses and paid down some of its debt between 1998 and 2000.

Base money growth rebounded following the 1921 Depression. But after 1923, the growth rate steadily declined during the rest of the decade. In 1928, base money began to contract. In April 1929, it fell as much as 2%. Prices began falling in July 1926 and fell consistently every month for the next three years. The deflation rate was -3.4% in April 1927 and -2.8% in June 1928. Weak money supply growth followed by a contraction in the money supply played a leading role in causing the deflation of the late 1920s.

For the decade, base money grew at an average annual rate of 1.6%. The inflation rate averaged 1.5% per year. These low averages mask very large swings in both the money supply and prices during the decade. The highest rate of money supply growth was 16% in 1919, while the lowest was -16% in 1921. Inflation peaked at 24% in 1920. Deflation was at its worst at -16% in 1921.

The 1930s

The Wall Street Crash of October 1929 brought the Roaring Twenties to an abrupt end. The Crash destroyed a tremendous deal of wealth and shattered business confidence. Prices began to fall. Then in late 1930 the first wave of bank failures began and turned what had been a recession up until then into the Great Depression.

In January 1930, the inflation rate had been 0%. By November prices were 5% lower than one year earlier. By mid-1931, they were 10% lower than in mid-1930 (see Chart 15.3). From then until March 1933, when Franklin Roosevelt became president, the annual deflation rate averaged 10%. Altogether, between the Crash and the presidential inauguration, the Consumer Price Index fell 27%.

Milton Friedman and Anna Jacobson Schwartz persuaded most of the economic profession that the Fed could have prevented the Great Depression if it had expanded the monetary base aggressively in 1930. While that is very likely true, the contraction of the money supply during 1930 by itself was not large enough to account for the severe deflation that followed.

CHART 15.3 Base Money vs. CPI: Percentage Change from Year Ago, The 1930s

Source: Data from the Federal Reserve Bank of St. Louis⁴

Base money contracted during 1930, but, at its lowest point, November, it was only down by 6% compared with one year earlier. The contraction in base money occurred because currency in circulation declined. When business slowed down, payrolls and prices fell. Consequently there was less need for cash.

Money supply growth resumed in January 1931 and continued through 1932 and into 1933 as the public's demand for cash increased as individuals became more fearful over the health of the country's banks and the security of their deposits. The Fed helped accommodate that demand through large-scale open market purchases in 1932 and 1933.

When the economic bubble of the 1920s popped, wealth was destroyed and credit contracted. Households and businesses no longer had the means to continue spending. They bought less and prices fell. Therefore, it was a deflationary demand shock, rather than a contraction of the money supply that was the main cause of the collapse in prices during the first years of the Depression.

President Roosevelt took the United States off the gold standard in April 1933 and then devalued the dollar in January 1934. Only then did deflation end. The devaluation of the dollar meant that foreign investors with gold could acquire US goods and assets at a much lower price than before. Consequently, gold flooded into the United States from abroad. That foreign capital inflow caused a new surge in US money supply growth. Between April 1934 and July 1936, base money grew at an annual average rate of 17%. The surge in the money supply, supported by expansionary New Deal fiscal policy, caused prices to begin to rise again from mid-1933.

Between May 1937 and June 1938, the country suffered another sharp economic slump, a recession within the depression. Fiscal austerity was to blame. The Roosevelt administration reduced the budget deficit from $4.3 billion in 1936 to only $89 million in 1938. The unemployment rate rose from a low of 11% in mid-1937 back to 20% in mid-1938.⁵

The money supply also contracted during this period. The Treasury Department began sterilizing gold inflows into the United States by selling bonds. The gold inflows added to the money supply, but the bond sales by the Treasury withdrew money from the economy, reducing the money supply in much the same way the Fed removes money by selling bolds through open market operations. Sterilization continued until February 1938. Afterwards, the money supply began to expand again.

The Consumer Price Inflation Index peaked in October 1937 and then began to fall again. The annual change in the inflation rate peaked at 5% in May 1937, but fell back below zero in March 1938. Deflation persisted until the first months of 1940, even though continued capital flight out of Europe and Asia caused another strong surge in the money supply from March 1938. The Fed's gold assets increased by 68% during the last two years of the decade due to those capital inflows. That caused the US monetary base to increase by 54% during those 24 months.

Looking back over the decade, the deflationary demand shock that followed the collapse of the 1920s economic bubble was the most powerful factor affecting prices during this period.

The expansion of the money supply following the devaluation of the dollar in 1934 also had a powerful impact on prices. It was the main factor that brought the deflation of the early 1930s to an end. New Deal fiscal stimulus also played a role.

The contraction of the money supply in 1930 contributed to the deflation that followed, but was a less important factor than the deflationary demand shock mentioned above. It is also probable that the money supply contraction during 1937 played a role in bringing about the deflation of 1937 and 1938. On the other hand, moderate money supply expansion from 1931 to 1933 did not end deflation during those years. Nor did a very robust expansion of the money supply during 1938 and 1939 end the deflation that prevailed then.

For the decade as a whole, base money grew at an average rate of 9% a year. Prices, meanwhile, fell by an average of 2% a year. The highest rate of money supply growth was 28% in 1939. The lowest was a contraction of 14% in 1937. The inflation rate peaked at 6% in 1934. Deflation peaked at 11% in 1932.

The 1940s

European gold continued to pour into the US during 1940. The Fed's holdings of gold certificates increased by another 29% in that one year alone. That caused US base money to expand by 20% during 1940, with the peak rate of growth at 27% in February (see Chart 15.4).

Thereafter, capital controls were imposed in Europe. Moreover, Lend-Lease meant England no longer had to pay with gold for the war materials it bought from the United States. Instead, those purchases were financed with credit provided by the US government. Consequently, the gold inflows into the US ceased and US base money leveled off.

Altogether between the end of 1937 and the end of 1940, US base money had increased by 85%. The impact of this explosion of money on inflation was negligible. Prices fell during 1938 and 1939; and the annual inflation rate for the 12 months of 1940 averaged only 0.7%. These years do not lend strong support to the claim that money supply growth always results in inflation.

To be fair, it is usually argued that money supply growth always results in inflation with a lag. Milton Friedman wrote in Money Mischief, “over the past century and more in the United States, the United Kingdom, and some other Western countries, roughly six to nine months have elapsed on the average before increased monetary growth has worked its way through the economy and produced increased economic growth and employment. Another twelve to eighteen months have elapsed before the increased monetary growth has affected the price level appreciably and inflation has occurred or speeded up.”⁶ In this case, inflation did turn positive in February 1940, 26 months after the surge in the money supply began. But inflationary pressures remained very muted until the second quarter of 1941. By then, Europe had been at war for a year and a half; and demand from Europe for US war materials and the United States' own military preparations that preceded its entry into the war had brought about a recovery in the US economy.

CHART 15.4 Base Money vs. CPI: Percentage Change from Year Ago, The 1940s

Source: Data from the Federal Reserve Bank of St. Louis⁷

When inflation did begin to rise in the second quarter of 1941, the inflationary demand shock brought on by World War II was the principal reason. The extraordinary surge in the money supply that began in 1938 probably did contribute to the pickup in inflation; but, if so, its role was much less important than the inflationary demand shock resulting from the war.

The US inflation rate rose from 1.4% in March 1941 to a peak of 13.2% in May 1942. It certainly would have continued rising had the government not imposed price controls soon after the United States entered the war in December 1941. Of course, the price controls resulted in shortages of many consumer goods, which imposed a different kind of burden on the public. Nevertheless, the inflation rate moved back down to 0% by May 1944 and it remained below 3% through the first quarter of 1946.

Price controls kept inflation contained even though the money supply effectively doubled during the war. Between 1941 and 1945, the Fed's holdings of US government securities increased from $2.2 billion to $19.4 billion. The money supply doubled because the Fed created money to pay for the government bonds it acquired.

When the war ended, price controls were gradually removed. As controls were lifted, inflation took off. The inflation rate rose from 2.8% in March 1946 to a peak of 19.7% in March 1947. The annual growth rate of base money peaked at 27% in 1943 and then began to slow from the end of 1944. By July 1947, it was down to 0.2%. In March 1948, it turned negative and it remained negative (ranging between -0.1% and -2.4%) until the Korean War began in mid-1950.

This monetary restraint was an important factor in the rapid fall in the inflation rate after 1947. Prices stabilized during the second quarter of 1949 and then turned negative. Prices fell every month between May 1949 and June 1950, when the Korean War started. The collapse in government expenditure after World War II also explains why the postwar inflation was so short-lived. Government outlays fell from $93 billion in 1945 to $30 billion in 1948. This was a deflationary demand shock that pushed prices lower.

Looking back over the decade, the inflationary demand shock brought on by the war was the principal cause of inflation during the decade. Money supply growth played a secondary role. When the war ended, the deflationary demand shock from the curtailment of government spending and monetary restraint both contributed to a rapid decline in inflation in late 1947 and during 1948. Of the two, the deflationary demand shock may have been more important than monetary restraint.

Base money grew at an average annual rate of 10% during the 1940s. Consumer price inflation increased on average by 6% a year. The highest rate of base money growth was 27% in 1940. The lowest was a contraction of 4% in 1941. Inflation peaked at 20% in 1947. Deflation peaked at 3% in 1949.

The 1950s

During the 1950s, money supply growth was tightly constrained and, other than during the Korean War, the inflation rate was low (see Chart 15.5).

The Korean War caused the inflation rate to jump from a low of -0.9% at the beginning of the decade to a peak of +9% in February 1951. Growth in the money supply was not to blame. President Truman insisted that the war be financed with tax increases rather than through money creation by the Fed in contrast to what had occurred during the two world wars. Consequently, money supply growth increased to only 5.3% in January 1952. That was its peak for the decade.

The inflationary demand shock of the war was responsible for the inflation that occurred during the 1950s. Government outlays increased from $43 billion in 1950 to $68 billion in 1952. After the war ended, however, this time there was no deflationary demand shock. Government spending didn't drop off after the war. It continued to expand, reaching $92 billion in 1959. The military-industrial complex that President Eisenhower warned about when he left office in 1960 became entrenched during the 1950s.

CHART 15.5 Base Money vs. CPI: Percentage Change from Year Ago, The 1950s

Source: Data from the Federal Reserve Bank of St. Louis⁸

Low money supply growth deserves the credit for the low inflation rates during the decade. Conservative fiscal policy helped. Although government spending increased steadily during the decade, so did tax receipts. Budget deficits were small up until 1959. Consequently, the Fed was not pressured to print money to help finance the budget deficits, as it came to be during the 1960s and beyond.

Base money and the inflation rate both grew at an annual average rate of 2% during the decade. The highest rate of base money growth was 5% in 1952. The lowest was -1% in 1950. CPI peaked at 9% 1951. Deflation peaked at -1% in 1954.

The 1960s

Money supply growth and inflation were both low at the beginning of the 1960s, but both accelerated as the decade progressed, as shown in Chart 15.6. Government spending on the Great Society social programs and the Vietnam War produced large budget deficits and the Fed was pressured to help finance them.

Between 1959 and 1969, the Fed's holdings of US government securities more than doubled from $27 billion to $57 billion. In 1959, the Fed owned 11% of all government bonds. In 1969, it owned 19% of a greatly expanded total.⁹ The Fed created money to buy the bonds. Base money increased 58% during the decade as a result. Money supply growth would have been greater still, except that the United States lost $4.5 billion of gold, 21% of its holdings, during the 1960s.¹⁰ The outflow of gold partially offset the money the Fed created to monetize the government's debt, making money supply growth less than it otherwise would have been.

The acceleration in money supply growth preceded the pickup in inflation and it was certainly an important factor in driving prices higher. Government spending, which doubled during the decade, also pushed prices higher.

CHART 15.6 Base Money vs. CPI: Percentage Change from Year Ago, The 1960s

Source: Data from the Federal Reserve Bank of St. Louis¹¹

Base money grew at an annual average rate of 4.5%. Its growth rate increased from 0% in 1960 to 7% in 1969. The average inflation rate was 2%. CPI was lowest in 1961 at 1%. The highest rate of inflation was 6%, recorded in December 1969.

The large budget deficits and excessive money supply growth during the 1960s set the stage for the breakdown of the Bretton Woods international monetary system in August 1971 – and the inflationary firestorm that followed.

The 1970s

In 1970, the United States experienced a mild recession. The government responded with increased spending that produced a large budget deficit in 1971. Money supply growth accelerated as the Fed created more money to help finance the larger deficit. Base money growth increased from 4.1% in January 1970 to 8.6% in July 1971 (see Chart 15.7).

If the Nixon administration's priority had been preserving the Bretton Woods system, it would not have run large budget deficits or encouraged rapid money supply growth. That was not its priority, however. President Nixon's priority was being reelected in November 1972. The combination of fiscal and monetary stimulus in 1970 and 1971 was the final nail in the coffin for the Bretton Woods system.

The Bretton Woods system broke down because by the early 1970s (and, in fact, for a number of years before then) the United States no longer had enough gold to allow other countries to convert the dollars they had acquired into US gold, as the system required. The convertibility of dollars into gold was the foundation upon which the Bretton Woods system was built. The additional fiscal and monetary stimulus during 1971, which was certain to cause even more dollars to end up in foreign hands, made it clear to the rest of the world that the United States would not be able to live up to it obligation to convert dollars into gold for much longer. The redemption of dollars into gold accelerated. Nixon, therefore, had no choice but to end convertibility of dollars into gold in August 1971. Had he not done so, the United States would have been drained of all its gold and the Bretton Woods system would have collapsed anyway.

CHART 15.7 Base Money vs. CPI: Percentage Change from Year Ago, The 1970s

Source: Data from the Federal Reserve Bank of St. Louis¹²

When Bretton Woods broke down, everything changed. Money was no longer backed by gold. Central banks were free to create as much money as they dared. Currencies were no longer pegged. They floated. Trade between nations no longer had to balance – so long as the trade deficits could be financed with money borrowed from abroad. In short, the orthodoxy that had governed economic policy making for more than a century was thrown out the window and a new paradigm began to take shape.

During the 1970s, these changes produced much higher rates of inflation, in the US and around the world. There were two inflationary oil supply shocks during the decade. The first in 1973–74 was the result of the Arab oil embargo. The second in 1978–79 was set off by the Iran–Iraq War. Oil prices spiked from $3.6 per barrel in July 1973 to $10 per barrel in March 1974. By the end of 1978, it had risen to $14.9 per barrel. It then spiked again to $39 per barrel by April 1980.¹³

First of all, it should be understood that the two oil shocks could not have occurred, or, at least, could not have persisted, if the world had remained on the Bretton Woods system. Many of the oil importing countries would not have had enough gold, dollars, or other gold-backed currencies to allow them to continue importing oil at the new elevated prices. As their gold reserves plummeted, they would have experienced severe economic crises and been forced to buy much less oil. The collapse in the demand for oil would have driven the price of oil back down.

In the post–Bretton Woods world, however, that scenario did not play out. The cash rich oil exporting countries deposited into US banks the money they earned from exporting oil and the US banks lent that money to the oil importing countries, enabling them to continue buying oil at the new high prices.

Therefore, oil prices remained elevated and the two inflationary oil supply shocks pushed inflation higher in the United States and around the world. The US inflation rate rose to above 12% in 1974, abated, and then climbed to more than 13% in 1979. It peaked at nearly 15% in March 1980.

Both oil shocks pushed the United States into painful recessions. Because the economy was weak, the government budget deficits were much larger during the 1970s (averaging 1.9% a year) than they had been during the 1950s (0.4% a year) and 1960s (0.7% a year). The Fed partially monetized those deficits by acquiring much more government debt with newly created money. The Fed's holdings of US government securities doubled during the decade, from $57 billion at the end of 1969 to $116 billion by the end of 1979. As a result of the Fed's purchases of government debt, money supply growth accelerated. Base money grew at an average annual rate of 8% during the 1970s. The inflation rate averaged 7% a year.

Both money supply growth and inflation would have been very much higher still had foreign central banks not stepped in and begun buying US government debt on a very large scale. At the beginning of the decade, the “rest of the world”, i.e., foreign buyers, owned $10 billion worth of US government securities, 3% of the total outstanding. By the end of the decade, they owned $116 billion or 16% of the total.

Had foreign central banks not begun buying huge amounts of US government securities, in all likelihood, the Fed would have had to acquire much more government debt than it actually did in order to prevent the increased government borrowing from pushing up interest rates, which would have negatively impacted economic growth and employment. If the Fed had monetized even more government debt, the money supply growth would have been much larger and inflation much worse.

The breakdown of the Bretton Woods system made it possible for the “rest of the world” to buy more US government debt. Once money ceased to be backed by gold in 1971, central banks all around the world were free to create as much money as they wished. Some central banks began creating their own currencies very aggressively in order to buy US dollars in order to hold down the value of their currencies relative to the dollar, so as to support export-led growth for their economies. Once they accumulated the dollars, they had to invest them in US dollar-denominated assets. That explains why the “rest of the world” began buying so many US government bonds during the 1970s. The emergence of large-scale money creation by the central banks of the trade surplus countries was to have an extraordinary impact on the global economy during the decades that followed.

US base money doubled during the 1970s from $63 billion to $134 billion. It is important to understand that that surge in the US base money could not have occurred if the Fed had still been required to hold gold certificates to back the money it created. As noted in early chapters, up until 1968, the Fed had been required to hold 25% gold certificate backing for the dollars it created. In 1968, the Fed had only enough gold certificates to meet that requirement. That meant the Fed could not have created any more dollars unless the outflow of gold from the United States had been reversed or unless the gold certificate backing requirement was reduced. That requirement was removed altogether by an act of Congress in March 1968.¹⁴ Consequently, the Fed was able to continue creating money and using it to buy government bonds in order to help finance the government's large budget deficits at interest rates that were lower than they otherwise would have been.

Looking back over the decade, the two inflationary oil supply shocks were the main reason for the high rates of inflation. The high rates of money supply growth were also a central reason the inflation rate rose as much as it did and remained as high as it did during this period.

The lowest annual rate of base money growth during the decade was 4% in 1970. The highest was 10% in 1973. It nearly reached 10% again in 1978. The lowest rate of inflation was 3% in 1972. The highest was 13% in 1979.

The 1980s

Globalization, in its modern form, got underway in the early 1980s when the United States began running very large trade deficits (see Chart 15.8). Under the gold standard or the Bretton Woods system, countries could not import more than they exported for very long because they were required to pay for their trade deficits with gold. Trade deficits drained money (i.e., gold) from their economies, caused severe economic slumps, unemployment, and deflation. Before long, spending fell, imports declined, and trade came back into balance.

All that ended when the Bretton Woods system collapsed. Afterwards, trade deficits did not have to be paid for out of a limited supply of gold reserves. They could be financed with money borrowed from abroad. Before long the United States began financing its extraordinarily large trade deficits by borrowing money from abroad, primarily money created by foreign central banks.

CHART 15.8 US Current Account Balance: 1947 to 2016

Source: Data from the Federal Reserve Bank of St. Louis

This new arrangement of financing trade deficits by borrowing newly created money from the countries with large trade surpluses completely transformed the global economy. Its impact was far greater than any other economic development over the last 40 years. The economics profession has still not grasped the significance of this radical break from the past. That is why most economists failed to anticipate the crisis of 2008 and why contemporary economic theory remains unable to explain many of the most important economic developments that have occurred subsequently.

During the 1980s, money supply growth remained high, but inflation began to moderate. The deceleration in inflation is not what would have been anticipated, given the large budget deficits run by the Reagan administration. During the five years between 1982 and 1986, the government's budget deficit averaged 5% of GDP per year. These were by far the largest budget deficits during peacetime in the nation's history up until then. For the decade, the budget deficit averaged 3.8% a year, twice the level of the already high deficits experienced during the inflationary 1970s.

Considering that the budget deficits during the Johnson and Nixon years had played a leading role in the acceleration of inflation in the late 1960s and early 1970s, the Reagan administration's much larger budget deficits should have caused a new bout of inflation during the 1980s. But they didn't. The inflation rate peaked at 15% in 1980 and then fell to as low as 1% in 1986 (see Chart 15.9). Why didn't the Reagan deficits cause inflation to accelerate?

The Fed likes to take credit for bringing down inflation after 1980. And it is true that Fed Chairman Volcker did bring inflation down by provoking a harsh recession with very high federal funds rates from 1980 to 1982. However, after that, the Fed has had very little to do with bringing down the inflation rate. Base money grew at an average annual rate of more than 9% between 1983 and mid-1987. So, inflation didn't come down because the Fed reined in money supply growth. The Fed didn't rein in money supply growth.

CHART 15.9 Base Money vs. CPI: Percentage Change from Year Ago, The 1980s

Source: Data from the Federal Reserve Bank of St. Louis¹⁵

Inflation came down because the US began buying more and more goods from low wage countries and that drove down wages and prices in the United States. In other words, inflation came down because of a deflationary supply shock – a deflationary labor supply shock.

Supply and demand determine prices. Before the US started running very large trade deficits in the 1980s, if US money supply increased rapidly, that would boost demand and result in full utilization of US labor and industrial capacity, leading to inflation. After the US began running large trade deficits, US capacity constraints no longer mattered – only global capacity constraints mattered.

Globally, there are no labor constraints. Hundreds of millions of people will work for less than $10 per day. Consequently, after the early 1980s, rapid money supply growth in the United States no longer resulted in high rates of inflation. Once the United States began running large trade deficits, the deflationary supply shock that resulted from globalization and a near infinite pool of ultra-low-cost labor held US wages and prices down, regardless of how large the budget deficits or the money supply growth became.

This deflationary labor supply shock has continued to be the main factor determining the inflation rate during the decades that have followed.

Looking back over the decade of the 1980s, base money grew at an average annual rate of 8%. Inflation averaged 6% a year. Base money growth peaked at 12% in 1987. Its lowest rate of growth was 4% in 1989. Inflation peaked at 15% in 1980. It bottomed at 1% in 1986.

The 1990s

During the 1990s, the trends that developed during the 1980s continued. Money supply growth remained high. Base money doubled again during those 10 years. Nevertheless, the inflation rate continued to move down (see Chart 15.10). The deflationary labor supply shock explains the disinflation. This was the decade when China entered the global economy and began running large trade surpluses with the United States. By the end of the decade the US current account deficit had grown to nearly $300 billion, more than 3% of US GDP.

CHART 15.10 Base Money vs. CPI: Percentage Change from Year Ago, The 1990s

Source: Data from the Federal Reserve Bank of St. Louis¹⁶

For the decade, base money growth averaged 8% a year. The average inflation rate fell to 3%. The highest rate of base money growth was 16% in 1999. That occurred because the Fed flooded the banks with money as a precautionary measure before Y2K. Other than that, the peak in base money growth occurred between late 1992 and mid-1994, at an annual average rate of 10% to 11%. The lowest rate of base money growth was 3% in 1996. CPI peaked at 6% in 1990. Its low was 1% in 1998.

2000 to Mid-2008

This section considers the years between 2000 and mid-2008 just before the economic crisis began. Base money growth slowed sharply after 2002. It fell from above 10% in 2002 to less than 1% during the first half of 2008. Inflation, on the other hand, rose during those years, from 1% in 2002 to 5% in mid-2008, as shown in Chart 15.11.

The acceleration in inflation over those years appears odd at first glance. Monetary policy was restrictive. The Fed hiked the federal funds rate by 425 basis points between mid-2004 and mid-2006, causing money supply growth to slow to lows not seen since 1960 (with the exception of two months in 2000 when the Fed unwound the Y2K money supply surge). Furthermore, the US current account deficit continued to widen, so the deflationary forces of globalization continued to exert downward pressure on US prices. What, then caused the pickup in the inflation rate?

The inflation rate accelerated because capital inflows from abroad resulted in such rapid credit growth in the United States that the country was blown into an economic bubble – despite the sharp reduction in the money supply growth engineered by the Fed. Foreign capital inflows, the mirror image of the US current account deficit, peaked at $800 billion or 6% of GDP in 2006. As the capital inflows grew larger, credit expanded. Total US credit growth increased from 7% in 2000 to 10.5% in 2007. Rapid credit growth pushed up prices; both asset prices and consumer prices. The credit bubble of those years produced an inflationary demand shock that drove US inflation higher. When the bubble popped in the second half of 2008, the inflationary demand shock it had caused gave way to a deflationary demand shock once credit began to contract.

CHART 15.11 Base Money vs. CPI: Percentage Change from Year Ago, 2000 to Mid-2008

Source: Data from the Federal Reserve Bank of St. Louis¹⁷

During these eight and a half years, base money growth averaged 5% a year, with much higher growth rates in the first half of the period than during the second half. Money supply growth peaked at 13% in January 2000. In December 2000, money supply contracted by 3%. The peak rate and the contraction were both related to the pre-Y2K money surge, which was partially unwound afterwards. The inflation rate averaged 3% a year. Inflation peaked at 5% in mid-2008, just before the crisis began. The lowest level of Inflation was 1% in 2002.

Mid-2008 to 2019

The period between mid-2008 and 2019 demonstrates in a dramatic fashion that changes in the money supply no longer have any discernable impact whatsoever on the rate of inflation. The following paragraphs will show that the largest annual increase in the monetary base ever recorded (109% in 2009) did not cause inflation to rise and that a very steep contraction in the monetary base in both 2016 and 2019 did not cause prices to fall. There could be no more conclusive proof than the evidence presented during this period that a fundamental economic change has occurred that has severed the causal link between changes in money supply growth and changes in the price level. The conclusion that must be drawn from these developments is that a paradigm shift has occurred in the way our monetary/economic system functions now that money is no longer backed by gold.

During the autumn of 2008, a systemic financial sector crisis came close to bankrupting every major financial sector institution in the United States. The Fed prevented that cataclysm by unleashing three tidal waves of money. See Chart 15.12.

Beginning with an extraordinary series of discounting operations that peaked at $1.5 trillion in late 2008, the Fed provided loans to all and sundry within the world of finance. Then followed three rounds of Quantitative Easing. QE1 began in December 2008 and lasted until March 2010. QE2 occurred between November 2010 and June 2011. QE3 extended for 24 months between October 2012 and October 2014.

In total, during the six years and four months between June 2008 and October 2014, when the third round of Quantitative Easing ended, the money supply increase by $3.2 trillion or by 365%. If inflation were always and everywhere a monetary phenomenon as Milton Friedman and other Monetarists believed, this flood of money should have quickly led to hyperinflation in the United States. It didn't. In fact, it was barely sufficient to prevent prices from falling. The inflation rate averaged 1.8% during that period.

During 2016, the monetary base contracted by 12% when the Fed entered into reverse repurchase agreements to absorb Bank Reserves. That was the largest contraction since 1937. During 2019, the monetary base shrank by 13% due to Quantitative Tightening, which began in October 2017 and ended in August 2019. Despite these exceptionally large declines in the monetary base, prices did not fall. The monthly inflation rate between January 2016 and July 2019 averaged 1.9%.

During this period, the highest annual rate of base money growth was 109% in 2009. The lowest was -13% in 2019. The largest rise in Inflation was 5.6% in mid-2008, before the crisis was fully underway. The highest rate of inflation after Quantitative Easing began at the end of 2008 was 3.9% in September 2011. The lowest rate of inflation was -2.1% in mid-2009.

CHART 15.12 Base Money vs. CPI: Percentage Change from Year Ago, Mid-2008 to December 2019

Source: Data from the Federal Reserve Bank of St. Louis¹⁸

2020 to Mid-2021

The Fed resumed creating money on a very large scale beginning in September 2019 in response to a disruption in the functioning of the market for overnight repurchase agreements. It then radically accelerated the amount of money it created beginning in March 2020 in response to the pandemic. Between September 2019 and June 2021, the monetary base surged by nearly $2.8 trillion, an 88% jump. The year-on-year peak rate of growth in the monetary base was 59% in May 2020. By June 2021, it had fallen back to 20%. Consumer price inflation moved up to 5.3% in June 2021.¹⁹ See Chart 15.13.

The 5.3% jump in the CPI in June 2021 was the highest since a 5.6% increase in July 2008. However, it is important to understand that this figure was distorted by the deflation that occurred during the second quarter of 2020. While the June 2021 CPI index was 5.3% above its level in June 2020, it was only 6% above its level in June 2019, meaning that the average annual inflation rate during the two years between mid-2019 and mid-2021 was a much less alarming 3.0%.

CHART 15.13 Base Money vs. CPI, Percentage Change from Year Ago, January 2020 to June 2021

Source: Data from the Federal Reserve Bank of St. Louis²⁰

The pickup in inflation during the first half of 2021 resulted from an inflationary demand shock and an inflationary supply shock. The government's extraordinarily aggressive fiscal policy response to the economic crisis caused by the pandemic produced the inflationary demand shock. Three very large rounds of fiscal stimulus, which included checks sent from the government directly to individuals, provided Americans with augmented purchasing power that fueled consumption and created higher than normal demand.

At the same time, the COVID-19 pandemic disrupted supply chains around the world, leading to supply shortages and higher prices for some goods. One of the most significant instances of this was a shortage of semiconductors used by the automobile industry. When the pandemic began, the automobile industry, mistakenly expecting a collapse in consumer demand, sharply reduced its orders from semiconductor manufacturers. By the time it became clear that there would not be a collapse in demand, it was too late for the semiconductor companies to produce all the semiconductors the automobile companies required. Consequently, there was a shortage of new cars and trucks during the first half of 2021. As a result of that shortage, the price of used cars and trucks jumped by roughly 40% in the second quarter of 2021 compared with one year earlier. That alone accounted for approximately one-third of the increase in the Consumer Price Index during the second quarter.

The elevated inflation of mid-2021 is unlikely to persist for long. The supplemental demand provided by the government's large fiscal stimulus packages has already begun to fade, and no other large government spending programs on the scale of the first three are expected. Therefore, the growth in consumer demand will slow during the quarters ahead. Demand will cool just as supply begins to expand as the supply bottlenecks stemming from the pandemic are overcome. The combination of weaker demand and increasing supply is likely to cause price pressures to abate.

By the end of 2022, the deflationary forces resulting from globalization are likely to once again become paramount, barring any new unexpected shocks. If so, the inflation rate may soon fall back below the Fed's 2% inflation target.

If large increases in the money supply inevitably produced high rates of inflation, as many believe, then the extraordinary surge in the US monetary base since March 2020 and the even larger increase in the monetary base following the crisis of 2008 should have set off hyperinflation in the United States. But that did not happen. The annual growth in the monetary base peaked at 59% in 2020. The average annual rate of inflation between mid-2019 and mid-2021 was 3%. The monetary base grew at a mind-boggling rate of 109% in 2009 and then by a further 34% in 2011 and by 39% more in 2013. And yet the peak rate of inflation following the financial crisis was 3.9%.

To put this into perspective, money supply growth peaked at what was then an unprecedented rate of 28% during World War II. Since 2008, growth in the money supply has exceeded the World War II peak four times (see Chart 15.14).

Why Prices Didn't Rise

From the end of 2008 to the middle of 2021, the US monetary base expanded at an average annual rate of 18%. Inflation, on the other hand, averaged just 1.7% a year. So why didn't the extraordinary surge in money supply growth cause very high rates of inflation?

The explanation is that, by 2008, money and the money supply had become largely irrelevant in terms of having a meaningful impact on prices. During the first half of the twentieth century, the money supply mattered because it determined how much credit could be created. The requirement that the Fed back the dollars it created by holding gold (or later gold certificates) and the requirement that the banking system hold a substantial amount of reserves to back the money (i.e., bank credit) it created, meant that the supply of money and credit was tightly constrained. However, during the course of the second half of the century, the Fed was freed from the requirement to back dollars with gold certificates and the banking system was, for all intents and purposes, freed from the requirement to hold a meaningful amount of Bank Reserves. Moreover, non-bank financial institutions that were not subject to any reserve requirements began supplying a growing share of credit in the economy. Lastly, foreign central banks began pumping trillion of dollars of credit into the United States.

CHART 15.14 Base Money vs. CPI: Percentage Change from Year Ago, 1919 to Mid-2021

Source: Data from the Federal Reserve Bank of St. Louis²¹

These changes meant that the money supply ceased to have any real influence over how much credit could be created in the United States. In the years leading up to the crisis of 2008, the financial system was free to create as much credit as it dared. The link between money and credit disappeared. More than that, money itself disappeared. When the Fed stopped backing dollars with gold certificates in 1968, dollars ceased to be money (as money had been defined in the past) and became simply another credit instrument issued by the government, a kind of non-interest bearing, small denomination government bond.

By 2008 – and long before – the money supply did not determine how much credit could be created. The only constraint on how much credit could be created was the financial ability of the borrowers to pay interest on the credit they borrowed. During the years leading up to 2008, the majority of the lenders in the US financial system misjudged – or simply ignored – that constraint and lent extravagantly. They then spiraled head-first toward bankruptcy when the borrowers defaulted. Afterwards, no amount of money supply growth could induce the financially crippled private sector to borrow and spend more. Consequently, a sevenfold increase in the money supply between mid-2008 and mid-2021 had almost no impact on inflation. Had the government not stepped in and begun borrowing on a multitrillion-dollar scale during the crisis of 2008, and again during 2020, then, in both instances, the economy would have collapsed, and severe deflation would have taken hold, just as occurred during the early 1930s after the economic bubble of the Roaring Twenties popped.

A new Great Depression was prevented by a policy response involving trillions of dollars of fiscal stimulus financed with trillions of dollars of money created by the Fed. Yet, despite this unprecedented fiscal and monetary stimulus, the average annual rate of inflation since mid-2008 has been 1.7%, below the Fed's 2% inflation target. These facts strongly support the idea that we are living in a new economic environment that opens up tremendous opportunities that did not exist in the past. Part Three describes those opportunities and the extraordinary benefits they offer if we make the most of them.

Notes

1. Friedman, Milton, Counter-Revolution in Monetary Theory. Wincott Memorial Lecture, Institute of Economic Affairs, Occasional paper 33, 1970, p. 11. https://miltonfriedman.hoover.org/friedman_images/Collections/2016c21/IEA_1970.pdf

2. This chapter begins with 1919 because the data series used for the monetary base, the St. Louis adjusted monetary base provided by the St. Louis Fed, begins that year.

3. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

4. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

5. St Louis Fed, FRED. https://fred.stlouisfed.org/series/M0892AUSM156SNBR

6. Milton Friedman, Money Mischief: Episodes in Monetary History, p. 221. A Harvest Book, Harcourt Brace & Company, 1994.

7. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

8. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

9. Financial Accounts of the United States, Tables L.106 and L.109, the Federal Reserve.

10. Banking and Monetary Statistics 1941 to 1970, St. Louis Fed. https://fraser.stlouisfed.org/title/banking-monetary-statistics-1941-1970-41

11. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

12. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

13. West Texas Intermediate, St. Louis Fed, FRED. https://fred.stlouisfed.org/series/WTISPLC

14. Public Law 90-269, 82 Stat. 50 – An Act to eliminate the reserve requirements for Federal Reserve notes and for U.S. notes and Treasury notes of 1890. Source: Govinfo. https://www.govinfo.gov/app/details/STATUTE-82/STATUTE-82-Pg50

15. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

16. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

17. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

18. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

19. Consumer Price Index for All Urban Consumers: All Items in U.S. City Average, Percent Change, Seasonally Adjusted, St Louis Fed, FRED. https://fred.stlouisfed.org/series/CPIAUCSL#0

20. January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers

21. 1919 to 2019: St. Louis Adjusted Monetary Base (AMBNS_PC1) January 2020 to June 2021: Monetary Base (BOGMBASE) CPI: Consumer Price Index for All Urban Consumers