Physicist John Stewart Bell said:
The scientific attitude is that correlations cry out for explanation.
Using the Federal Reserve’s data, see the Consumer Price Index (blue line) left axis and M1 Money Supply (red line) right axis for the 14 month period of January 2021 to February 2022:
Regression statistics reveal a correlation coefficient of 0.989 and an R-Square of 0.979. This begs explanation.
For the last 14 months, the CPI and the M1 Money Supply moved in near perfect positive harmony, despite one being a price index and the other measured by the trillions. While near perfect correlation between two variables is noteworthy, it does not prove one variable caused the other. Even if the correlation coefficient was 1.0 rather than 0.99, it would still be insufficient to prove causation.
Frank Shostak writes on the limitations of quantitative economics. Recently, in his article Quantitative Methods Are Incomplete When Used for Economic Analysis he wrote:
Various quantitative methods are a way of describing but not explaining events.
Finding a correlation of 0.99 is immaculate. However, it only indicates what happened. It cannot explain why. A theory is needed on how this is possible and whether it is indicative of a causal relationship.
By showing the 0.99 correlation between CPI and M1 is not accidental, that A precedes B, and no other variable can explain this relationship, it’s possible to sufficiently prove causality.
To claim this near perfect correlation to be mere coincidence ignores the known relationship between money supply and prices. Austrians note currency debasement occurs when governments or central banks engage in pro-inflation policies, inevitably leading to currency collapse. CPI and M1 have limitations but attempt to quantify ideas including the loss of purchasing power of money. A highly positive correlation between the two is not surprising. It’s actually expected.
The existence of a temporal relationship can be proven through thought experiments utilizing the history of fiat currencies. We also need to consider what would happen if the M1 did not increase by $2.5 trillion in the last 14 months, being held constant. Could the CPI have risen to these new highs?
Lastly, the possibility there exists a third factor which is the cause of the CP1/M1 correlation must be ruled out. Yet no alternative factor or credible theory has been identified. To say COVID or a Putin Price Hike caused unilateral price increases is one thing, but explaining how the money supply miraculously followed suit for the last 14 months is another. This unidentified factor would have to explain the increases and co-movements between CPI and M1.
What started with blaming COVID, turned into transitory inflation, bottlenecks, supply shortages, entrenched inflation, blame COVID again, now blame Putin. Blame everything except the Federal Reserve who not only took part in expanding the money supply by many trillions of dollars in the last two years but allowed it.
The limitations in data are clear. The CPI attempts to measure the immeasurable. It cannot adequately measure the prices of all goods and services nor purchasing power; CPI exemplifies statistical bias at best.
M1 money supply, prone to changes, is just one of several money supply measures. As recently as May 2020, the Fed changed the definition of M1. The action “increases the M1 monetary aggregate significantly,” thus, the money supply is not consistent. With various definitions of money supply, the concept of what constitutes money continues to be contentious. (Articles on the True Money Supply (TMS) developed by Rothbard and Salerno can be found here and here).
It’s tempting to use past data to extrapolate the future. For example, a model could show that for every trillion dollars increase in the money supply, 8 points are expected to be added to the Consumer Price Index. This is a principle of Econometrics, holding the position that the past relationship continues indefinitely, contrary to human action. It’s interesting estimating such things, but it fails to recognize the difference between human behavior and mere objects, and could be dangerous if used as a government planning tool.
The purpose is not to use a model to predict inflation, rather, it’s to utilize data to describe and provide a visual aid of one of the most important, yet grossly neglected causal relationships in economics. Inflation is not necessary. It can and should be stopped because no amount of inflation can be considered beneficial to the public. As Mises said: Inflation is a policy. It’s a policy paid by the masses, allowing them to better serve the most powerful members of society.
