Inflation: Monetary or Economic Phenomenon?

A clarification to my post on the economy yesterday:

My comment about the "sometimes-circular logic" of the bond market was not an endorsement of the way the bond market thinks. In earlier posts I've made it clear that I think the bond market is underestimating the risk of higher inflation. One reason for that is that both the bond market and the Fed believe that inflation is largely a function of the strength or weakness of the economy. Call it the Phillips Curve theory of inflation.

As a supply-sider and as a monetarist, I believe that inflation is a monetary phenomenon. I think low inflation is conducive to stronger growth, whereas the Phillips Curvers believe that stronger growth is conducive to higher inflation.

The belief in the argument that growth causes inflation is based on the observation that inflation tends to decline in the wake of a recession. Correlation is not causation, however. Every one of the post-war recessions that we've had have been the result of a significant tightening of monetary policy. (See my posts on the real Fed funds rate and the slope of the yield curve.) So the real cause of declining inflation has always been tight money, not weak growth.

I've been pointing out for months now that despite the economy having hit a major air pocket, there has been no noticeable decline in core inflation. This contradicts the expectations of the Phillips Curvers, and supports the logic of the monetarists. Furthermore, collapsing energy prices have been the major factor depressing inflation to date, and now energy prices are rising again.

As for taxes, the market is correct to assume that higher taxes to fund Obama's expansion of government will tend to weaken the economy. But that doesn't mean that inflation is going to be low forever, as the bond market currently assumes. The inflation threat is independent of the course on taxes. Of course, it's possible that the Fed could try to soften the blow of higher taxes by keeping monetary policy accommodative, but that would only increase the eventual inflation problem.

Finally, I've mentioned before that I don't think higher Treasury yields are necessarily a threat to the economy. Higher Treasury yields will be a good sign that the economy is improving. The economy has thrived for years during periods of rising interest rates. Treasury yields are so low now that they could rise hugely before they posed a threat to the economy. We would need to see a monumental increase in the real Fed funds rate (which is currently negative) and a major flattening of the yield curve (which is now very positively-sloped) before higher interest rates would pose a threat to growth.

Comments

[Warren B. M...:]

the currency is a (simple) public monopoly

the funds to pay taxes come only from govt spending/lending

Tax liabilities constitute the notional demand

The supply to fill the demand to pay taxes and net save comes from govt spending

The monopolist is always 'price setter'


the price level is necessarily a function of prices paid by govt when it spends (and/or collateral demanded when it lends)

see 'soft currency economics' at
mosler.org
moslereconomics.com
mosler2012.com

May 14 08:39 AM

[MGA_1:]

Artificially low interest rates = excess credit and easy money -> Boom (Inflation)

Inability to pay for loans -> Bust (Deflation)

Only problem is that the govt isn't liking the Bust part.

May 14 10:02 AM