Smoke, Mirrors, and Inflation Expectations
Some influential commentators believe that the Federal Reserve's timing for the withdrawal of its record monetary stimulus could be determined by inflation expectations. (A popular measure of inflation expectations is the difference between the interest rate on the 10-year Treasury note and the interest rate on the 10-year Treasury inflation protected security [TIPS].) After settling at 1.5 percent in August last year, this measure of inflation expectations shot up in April to 2.6 percent. For most experts, including Fed chairman Ben Bernanke, inflationary expectations are the underlying driving force of the inflationary process as depicted by changes in the consumer price index (CPI). (In fact there is a time lag between changes in inflation expectations and the yearly rate of growth of the CPI [see chart].)
These commentators believe that there are various shocks that could increase inflation expectations and in turn the rate of inflation. For instance, if a sharp increase in the price of oil caused higher inflationary expectations, this could set in motion spiraling price inflation.
If somehow expectations could be made less responsive to various price shocks, then over time this would mitigate the effect of a price shock on price inflation. So is there a way to make these expectations less sensitive to various price shocks?
Bernanke and other experts believe that it is possible to bring inflationary expectations to a state of equilibrium by means of transparent central-bank policies. In such a state of equilibrium, they argue, expectations are perfectly anchored or are not sensitive to changes in various economic data.
According to this way of thinking, once inflationary expectations are well anchored various price shocks such as sharp increases in oil or food prices are likely to be of a transitory nature. This means that over time price shocks are unlikely to have much effect on the rate of inflation.
Note that what matters in this way of thinking is the underlying price inflation. Therefore, the Fed chairman and many economists believe that to be able to track underlying inflation they must pay attention to core inflation — percentage changes in the consumer price index less food and energy.
According to Bernanke and other experts, it is difficult to bring inflationary expectations to a state of equilibrium as long as individuals are not clear about the precise inflation goal that Fed policy makers are aiming at.
Absolutely nothing is said here about the possible role that changes in the money supply might have on general increases in prices. Without a preceding increase in the money supply there cannot be a general increase in prices (which popular thinking labels as inflation).
Can There Be Inflation without an Increase in the Money Supply?
Now what is a price of a good? It is the amount of dollars paid per unit of a good. Obviously then, for a given amount of real goods, if the stock of money remains unchanged, the amount of dollars spent per unit of a good will also stay unchanged (all other things being equal). In order to have a general increase in prices we must have an increase in the stock of money. Could inflation expectations then cause a general rise in prices without the preceding rise in the money supply?
Let us say that on account of a sudden sharp increase in the price of oil, people have formed higher inflation expectations. If the money stock remains unchanged, then no general increase in prices can take place, all other things being equal. All that we will have here is a situation where the prices of oil and energy-related goods go up and the prices of other goods and services go down.
Contrary to Bernanke and mainstream economists, it is changes in the money supply — not expectations of inflation — that underpin general rises in prices. Without support from the money supply, no general acceleration in price inflation can take place, regardless of inflation expectations.
In fact, various so-called price shocks tend to come mostly because of preceding increases in the amount of dollars generated by the Fed and the banking system.
When new money is generated, it does not enter all markets instantly. It moves sequentially from one market to another market — there is a time lag between changes in money supply and changes in the prices of goods and services. For some goods the time lag tends to be short, while for others it can be very long.
This doesn't mean that a rise in the price of a particular good cannot be caused by a sharp fall in its supply. But a general increase in the prices of all goods cannot take place without preceding increases in money supply.
Most economists are dismissive of the money supply as far as general rises in prices of goods and services are concerned. The main reason for this is that the money supply is not always well correlated with changes in various price indexes.
On account of the variable time lag from changes in money to changes in various price indexes it is not always possible to articulate graphically the importance of money in driving general rise in prices.
What matters here, however, is not a statistical correlation as such but whether it is logically possible to have a general rise in prices without a preceding rise in money supply.
The yearly rate of increase in our monetary measure AMS from 2.4 percent in June last year to 10.6 percent in May this year raises the likelihood of a sharp increase in the growth momentum of the CPI in the months ahead (see chart).
The upward pressure on the growth momentum of the CPI caused by this strong increase in money supply cannot be neutralized by a transparent policy on behalf of the Fed. Again, this likely increase in the yearly rate of growth of the CPI is not going to come on account of an increase in inflation expectations but rather on account of the increase in the money supply, all other things being equal.
In fact an increase in inflation expectations always comes ultimately in response to rises in money supply. (An increase in the money supply pushes prices in general higher and this in turn lifts inflation expectations.)
The recent increase in inflation expectations may set the timing for the US central bank to start removing its record monetary stimulus. For the time being, Fed chairman Bernanke and other experts believe that the various shocks behind the increase in inflation expectations are of a transitory nature. This means that over time price shocks are unlikely to have much effect on general increases in prices. Hence the experts hold that as long that the Fed remains transparent regarding its policy, these shocks are not going to have much effect on the underlying rate of inflation. But in this way of thinking nothing is said about the role that changes in money supply have on general increase in prices.
Notwithstanding inflation expectations, a general increase in prices cannot emerge without a preceding increase in the money supply. A visible increase in the growth momentum of the money supply during June last year and May this year has already set the foundation for a further strengthening in the growth momentum of the CPI.
 Ben S. Bernanke. ‚Inflation Expectations and Inflation Forecasting.‚Äù July 10, 2007, speech at the NBER.
 There won't be enough money to cause a general increase in prices.
 Frank Shostak, "The Mystery of the Money Supply Definition," Quarterly Journal of Austrian Economics, volume 3, number 4 (Winter 2000).
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