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The correlation between money growth and subsequent inflation has as long a pedigree as any relationship in the social sciences. There are elements of the idea in Aristotle, and the concept was well understood by the time of Henry VIII. Milton Friedman famously quipped, “Inflation is everywhere and always a monetary phenomenon.”
This is why recent developments in money supply are raising eyebrows among economists. M2, the most commonly used measure of money, has increased 19 percent since Feb. 24, the fastest six-week pace of growth in 40 years. Many are asking, does this mean inflation is coming?
The reason for the money growth is straightforward. To combat the reduction in total demand from the pandemic lockdown, The Fed is pumping billions of dollars into the economy. The hope is that resulting record-low interest rates will convince consumers to buy and businesses to invest. As the (COVID-19) lockdown relaxes, the hope is for a quick recovery.
The Fed’s strategy may be working. The June relaxation in the lockdown was accompanied by record high employment growth. The Fed’s actions, especially support of financial markets and increasing the money supply, facilitated this recovery.
This is good news, and most think The Fed’s actions supporting the economy are justified. But what about after the pandemic? Are we in for a bout of post-COVID inflation?
Perhaps, but probably not. For 200 years, the United States enjoyed stable prices. Then came the 1970s and the bout of inflation associated with the Vietnam War. To quell inflation, The Fed raised interest rates dramatically, reaching 22 percent in December 1980. That quieted inflation but also caused as sharp recession.
Forty years later, people have forgotten the inflationary ‘70s. Most were not even alive then. People have come to take low inflation for granted. Expecting little inflation, workers are willing to accept modest pay increases, so costs raise slowly. At the same time, businesses can’t raise prices for fear their competitors will underprice them. Thus, low-inflation expectations lead to low inflation, which leads to low-inflation expectations, and so on.
This virtuous cycle coupled with the current 11 percent unemployment rate gives The Fed a great deal of running room. It can increase money growth, yet, at least in the short run, inflation remains steady. For right now, there is little inflationary pressure.
Post-COVID, when unemployment returns to normal and people begin to spend again, will inflation accelerate? As it turns out, The Fed has a trick up its sleeve that wasn’t available during prior inflationary episodes. Prior to 2007, The Fed paid zero-interest bank reserves. This provided banks with an incentive to lend out any excess over the legal 10 percent reserve requirement and keep loans at the maximum allowed. Any increase in the monetary base increased lending by banks, hence, spending by consumers and businesses.
Now that The Fed has started to pay interest on bank reserves, it has an additional powerful tool for controlling bank lending. By paying more on reserves, The Fed incentivizes banks to lend less and hold excess reserves. By throttling back on bank lending, The Fed can cool inflation by slowing consumer and business spending.
Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He remembers the 1970s. The opinions expressed may not be shared by the regents and administration of NMSU. Contact him at firstname.lastname@example.org.