Post 10 – Inflation
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” —John Maynard Keynes
“It is a way to take people’s wealth from them without having to openly raise taxes. Inflation is the most universal tax of all.” —Thomas Sowell
Prices are the exchange rates between money and goods and services. If rates of money growth exceed growth rates in the production of goods and services, prices will rise.
Inflation refers to a persistent increase in prices. Inflation is caused by too rapid growth in the money supply. Since the Federal Reserve controls the money supply, inflation is caused by the Federal Reserve.
When I was in graduate school in economics, this connection between inflation and too rapid growth in the new money was so theoretically and empirically well-documented by Milton Friedman and others that any student forgetting this relationship would have failed. Astoundingly, the current Federal Reserve leaders, to our detriment, are incorrectly focusing on interest rates rather than on money growth. There are economists who are trying to call attention to this. One is Professor Steve Hanke of Johns Hopkins University, and you can see him discuss these issues at
Inflation Just Got Lower, What’s Next? Economist Steve Hanke’s 2023 Forecast – YouTube
Inflation is different than increases in prices due to a key input, such as energy, becoming more expensive. Once prices adjust to the more costly input, price increases stop.
Prices do not stop rising during an inflation. For an analogy, consider water going into a bathtub that is full (economy at full rate of production) at the same rate that water drains from it. The bathtub will remain full of water. However, if you increase the rate of water (money) inflow, then water will overflow the tub and cause damage (inflation).
Unless other policies interfere, if the economy is not at maximum production (bathtub is not yet full), an increase in money (water) growth will induce real production to expand until it cannot increase any faster (until the tub is full). At that point any higher growth rate in the money supply will translate into a higher inflation rate (overflow). An inflation rate will persist as long as the accompanying rate of growth in the money supply persists.
When I was a professor at the University of Houston during the late 1970s and 1980’s, I co-authored an article in the Journal of Finance demonstrating that a quarterly increase in the money supply (M2) will influence the dollar volume of national output each quarter for about two years. This impact over time results from the new money circulating through the economy. Assessing the lagged effects are tricky because future variations in the money supply will also be influencing the economy during the impact periods of earlier changes.
Here is the source of current inflation. In the year ending January 1, 2020, the M2 money supply had grown at a 6.69% annual rate. The Biden administration, which came into office at that time, increased government spending by 67% in one year, some due to sending people money during the Covid lockdown. This spending was financed by borrowings through issues of government securities. The Federal Reserve chose to buy a heavy portion of these securities, injecting new money into the economy, rather than allowing interest rates to increase with the borrowing. I said as such in the Wall Street Journal, May 30, 2023 issue.
The Federal Reserve increased the money supply in the first five months of 2020 at a rapid rate. Its growth rate for the year ending May 2020, only five months later, had increased to 22%, and for each of the next ten months money grew from a year earlier at greater than a 20% pace. The “tub” was overflowing.
Here is a broader view. The two-year average growth rates in the M2 money supply ended January 1 for 2018, 2019, and 2020, respectively, are 5.59%, 3.18%, and 5.18%. The two-year averages for the consumer price index ending the same periods are 2.13%, 2.37%, and 1.87%.
For the two-years ended 2021, 2022, and 2023, the money supply growth rate was 19.52%, 16.27%, and 4.66%, respectively. The slowing for the two-years ended January 1, 2023 was due to reductions in the money supply in late 2022. Declines in the money supply are continuing as I write (mid-2023), The two-year inflation index for the same periods are 1.26%, 4.96%, and 7.87%, respectively. Note the lag in the impact of the rapid money growth on the inflation rate.
Due to lagged impacts, the inflation rate will likely decline to the 3-5% range for 2023. Since prices are not perfectly flexible downward, when money growth is abruptly decreased the real output growth in the economy will likely decline, also. The abrupt slowing in the two-year averages of money growth, from the high teens in 2021 and 2022 to 4.66% for the two-years ending January 1, 2023, along with the declines in the money supply during 2023, raise the prospect not just of slower economic growth but of a recession.
The government requires us to hold our retirement funds in liquid assets, such as cash, short term securities, bonds, or stocks. This is why inflation so easily damages our retirement funds. Unless our rate of earnings on financial investments exceeded the inflation rates in recent periods (if yours did not, don’t feel alone), our retirement funds have decreased in purchasing power during that time. For example, over the last two years, your rate of earnings on financial assets had to be 7.87% per year to maintain purchasing power.
Government finances its debt with new money (don’t you wish you could??) and you and I pay in loss of purchasing power of our retirement funds. The same is true for our wages, interest earnings, and dividend income, if any of these apply.
“Inflation is taxation without legislation” —Milton Friedman
“Inflation destroys saving…” —Kevin Brady
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