News in Charts: The dangers of inflation through a monetarist lens

Pure monetarist theory asserts that growth in an economy’s money supply translates directly into higher prices. This stems from an identity stating that the value of all expenditures in an economy is equal to the stock of money multiplied by how quickly that money is spent. Formally[1]:

As an identity, this statement is hardly controversial among economists, but the way in which it is interpreted is.

One controversy arises from the monetarist assertion that the velocity of money is close to stable and is predictable. If true, and if we assume that in the long run there is no impact on real expenditures, then the price level and the money supply are inextricably linked. As the chart below shows, the implied velocity of money (as measured by the ratio of the M2 money supply to nominal GDP) was indeed broadly constant up to the start of the 1990s. However, since then the trend (as measured by a simple HP filter) has begun to wander, with more rapid circulation in the late 1990s followed by a long downward trend. That said, even if the velocity changes over time, it tends not to deviate too far from trend, so we cannot so readily dismiss the assertions of monetarist theory.

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So, what does this mean for inflation? An equilibrium correction model suggests that deviations in the velocity of money from trend typically narrow at a rate of about 10% per quarter. So, assuming that the ‘velocity of money gap’ closes at that rate, and that money supply grows at 5% per annum, and that real GDP grows in line with Fathom’s central forecast, then the identity outlined above suggests that US inflation could reach double digits. Even a more benign scenario, where velocity behaves as it did in the aftermath of the global financial crisis, would result in price growth well above the Fed’s inflation target.

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Should we really expect US monetary velocity to revert to trend so quickly? A monetarist would probably argue “Yes”, reasoning that the velocity of money looks absurdly low, given the  rapid increase in the money supply that has taken place during the pandemic, and the progressive lifting of the curbs that restricted how that money could be spent. Once the constraints on activity are relaxed, if money begins to circulate at least as quickly as it did before, we would expect to see much higher inflation in the coming quarters.

Moreover, the pandemic has yielded a more direct policy response than the Global Financial Crisis did. This time round, cash payments were made directly to households, fuelling the sharp rise in M1 (narrow money in the form of currency and deposits held by households); whereas before, money creation primarily flowed from QE, yielding asset (as opposed to consumer) price inflation.

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However, all of this assumes that prices will make the adjustment required for velocity to return to normal. There are, of course, other possibilities. For instance, it is possible that a portion of the increase in the monetary stock might be unwound via deleveraging. In other words, we could see a fall in 𝑀𝑡 rather than a rise in 𝑃𝑡,¹ as firms and households repay debt. Survey data from the New York Fed suggests that roughly a third of US stimulus cheques are being used in this way.

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Overall, it seems higher inflation is around the corner. The signals from the monetarist arithmetic are worrying and, given their magnitude, it would be foolish to discount them. However, monetarist theory can be an unreliable friend in forecasting the evolution of prices. There is a reason why central banks, and Fathom, tend not to rely on such frameworks.

[1] In the identity,  represents the velocity of money,  represents the money supply;  represents to the quantity of all goods purchased (i.e. real GDP) and  represents the price level in the economy.