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Necessary But Not Sufficient – Money Supply and Inflation

             Monetary policy and the inflation are getting a lot of headlines in the media these days, and many are concerned that monetary policy is going to fuel run-away inflation. Both the Monetarist and Austrian economic schools posit that an increase in the money supply leads to inflation, defined as an overall increase in the cost of living. I argue that an increasing money supply is a necessary but not sufficient condition for inflation[1].  I’m not saying that printing money can’t lead to inflation but rather stating that the historic evidence fails to support the argument that the trajectory of the money supply is the only influence on inflation. Below I provide two examples in recent history where a rapid increase in the money supply has failed to result in inflation.
            Before I delve into my first example, I think it is important to clarify how I am defining inflation, since the term can take on different definitions depending on who you ask. The definition of inflation that I am using is a general increase in the cost of living, and I think the consumer price index is a good a barometer for this. The CPI is a weighted aggregate of the price level of energy, commodities, housing/rents, and common goods and services. Thus, if energy prices are going up, but housing prices are declining, the two index items will offset one another to some degree. I think the CPI does as good a job as any of the measures used by economists. Many have valid criticisms[2] of the various indices, but I think they all at least give a directional sense of the price level.  
            One of the more popular counterarguments against Monetarist and Austrian doctrine is Japan’s Lost Decade(s). Since 1986, Japan’s money supply as measured by M1 has quintupled, yet it has failed to emerge from two decades of deflation. Japan adopted quantitative easing measures in 2001 and increased its monetary base by 66% by 2006. The chart below shows Japan’s growth in M1 (red line) and Consumer Price Index (blue line). Japan is the second largest economy in the world, and, despite all its monetary efforts, it’s still in deflation.  

Similarly, the chart below shows the United States M1 money supply measure (in red) and the seasonally adjusted annual change in the consumer price index (in blue) since 1960. Many attribute the rapid growth of the money supply in the 60’s with the higher inflation in the 70’s. Looking at the chart one might discern a pattern of money supply growth followed by inflation with a lag of two years or so during that time. However, it’s hard to make the same argument anytime since. In fact, since 1981, after Fed Chairman Volker beat inflation, the money supply of the United States has grown from $400 billion to $1.7 trillion as measured by M1. This is a quadrupling of the money supply in thirty years with an average growth rate in the money supply of 5% per year, yet inflation has averaged close to 3% during this time. The last reading of US CPI indicated inflation grew 1.1% Y/Y in September of 2010, which marks the two year anniversary of when the Fed doubled its balance sheet to stave off the collapse of Wall Street. Perhaps QE2, which increases the money supply another 30%, will finally bring about inflation in the US, but we have yet to see meaningful inflation.

          These two examples are meant to splash some cold water on the inflationist sentiment being brought to a boil in the media.  Yes, the Fed has pumped trillions of dollars into the financial system over the last couple of years, but the financial system has also lost trillions of dollars in credit write-downs resulting in inflationary forces being largely offset by deflationary forces.  Going forward, while I don’t advocate QE2, I don’t think monetary policy will spur inflation when unemployment is still just south of 10%, and US capacity utilization remains below 80%.  Until demand returns to soak up spare capacity, I think we’re more likely to join Japan than revisit the stagflation of the 70’s. Of course, I’ve been wrong before

[1] Note the opinions of the author do not necessarily represent those of ZWJ Investment Counsel
[2] I’m happy to incorporate a better data series into my analysis if one can provide it. 

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.