Thursday, 1 May 2014

Why no inflation?

"Inflation is always and everywhere a monetary phenomenon."

Thus spoke Milton Friedman.

In the long run expansive monetary policy (measured via changes in money growth) can only deliver higher prices (one cannot print their way into prosperity - just look at Zimbabwe). If a country's central bank prints too much money its value goes down so prices go up, while the opposite - deflation - occurs if the central banks fails to supply enough money. However in the short run the connection is not as strong. 

Not all price changes result in (or a consequence of) inflation. It is usually also important to look at the velocity of money in explaining the movements of prices. Sure the majority of inflationary pressures can be attributed to monetary growth but in times of a liquidity trap the velocity of money will paint a much clearer picture of expected inflation.

To define it precisely velocity of money represents the average rate at which money circulates in the economy, i.e. the rate at which goods and services are bought and sold. Usually if consumption is low velocity is likely to be low as well - people spend less so money circulates slowly. Furthermore as I've pointed out earlier velocity of money tends to move very closely with the employment-population ratio (the real labor market indicator), which also makes perfect sense - if the labor market hasn't recovered neither will the rate at which people spend their money. 

Velocity is calculated simply: dividing nominal GDP by M2 money supply. Since we know that the denominator is growing much faster than the numerator, naturally the ratio is decreasing. As can be seen in the graph below - velocity is on its lowest ever level since WWII and the Great Depression (the full data is here).
Source: St. Louis Fed
This again does not mean that high velocity will lead to high inflation, but low velocity will surely prevent inflation from occurring. Basically we can say that the decline in the velocity of money has offset the average annual money growth. Or if you want, the decline in NGDP (fall in employment and consumption) has offset the money growth which is exactly why inflation hasn't occurred. 

Interest rates and tight money

What about low interest rates? How come they aren't causing inflation? Or at least higher inflationary expectations? Milton Friedman again has an answer: 
"Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy." 
"After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."
Friedman predicts that if interest rates are low, inflation will not tend to go up but down. This is exactly what Japan went through in the past two decades and exactly what Europe and the US are currently in. Inflation is low since interest rates are low - i.e. since money is tight! As Scott Sumner clearly says - monetarists don't think low interest rates imply easy money. 

Yes, it is somewhat strange to claim money is tight with all the QE being done, but there is an explanation for this as well. And it goes back to the velocity of money. Inflation hasn't kicked in since velocity is still low, or in other words the NGDP still hasn't really recovered. Plus all the QE didn't turn up in the real economy, it's still mostly stuck with the banks. Even the companies are hoarding mass amounts of cash.

If the economic recovery remains to be disappointing (the likelihood of which is very possible) then we can observe this "tight money" situation for a long time. Inflation will still be borderline deflation and monetarists will still be calling for "easier money". Not via raising interest rates of course, but by proposing things like NGDP targeting or credible signaling of easier long term monetary policy (I've summed up the gist of their ideas here).

For the record I'm even more convinced that the crisis was far from an AD shock and cannot be helped with either monetary or fiscal stimuli. If it could it would have already been helped - there is a reason why velocity is low and banks and companies are hoarding cash. 

This clearly is a structural shock. Pumping money in a low interest rate environment while debt ratios are still rising in addition to episodes of wrong austerity policies is a lethal combination that perfectly emulates Japan. And today even Abenomics can't help them. At least not the two arrow approach. Europe needs to be ready for at least one "lost decade" of stagnation. This is relatively easy to endure for rich countries like the UK or Japan, but much harder for relatively poorer countries in Europe which need their growth to catch up. 

So now we're actually facing deflation?

This appears the be the headline nowadays. Sweden is the latest country to experience a deflationary episode. Krugman reports:
"It’s amazing: Sweden, which at first weathered the crisis fairly well, and faced none of the institutional constraints of the euro area, has managed — completely gratuitously — to get itself into a deflationary trap."

However the interesting point about Sweden is that they've raised their interest rates during the crisis (remember, Sweden is not in the Eurozone), which has led to a temporary deflation episode. This is why Krugman criticizes the Swedish C.B. and how they failed to listen to Lars Svensson and his warning signs. So in this situation low interest rates will result in low inflation (however due to low velocity), while raising them will lead to deflationary pressures. 

I'm not sure this deflationary episode will last, however. Inflationary expectations in Sweden are still high (besides it didn't take long for Sweden's finance minister Andres Borg to react debunking the whole story). The fact that some EU countries were hit by a temporary deflation episode was primarily due to no major food or oil price shocks recently. I don't think Sweden or Europe are falling in a deflationary trap. Perhaps a slow-growth trap (not Sweden but Europe) with Japanese descent, but definitely not a deflation spiral, as some seem to claim. 

Finally to wrap this up, here's from an older blog post from Mark Thoma
"While many factors affect prices that are beyond the Federal Reserve’s direct control, eventually monetary policy tends to re-emerge as the key driver of inflation. After abstracting from short-term movements caused by economic disruptions, recessions, and wars, inflation is ultimately a monetary phenomenon: since 1929, the average annual percentage increase in the GDP deflator has been 2.8 percent, and the average annual growth in excess money has been 2.9 percent."
Good, in the long run the old story still holds. At least some certainty in today's uncertain world. 


  1. Hi Vuk, it's tight money -> low interest rates, not the other way around (that is what Sumner criticized the neofisherites/n.smith in the post).

    "This clearly is a structural shock. Pumping money in a low interest rate environment while debt ratios are still rising in addition to episodes of wrong austerity policies is a lethal combination that perfectly emulates Japan. "
    Are you saying the money was tight or not in Japan?

    I understand "pumping money" here as easy policy. If inflation and ngdp (or even interest rates if you agree with Fridman) signal tight policy as you noted, why not "pump money" until one gets what one sees as a "just right" policy?

    Lars Svensson showed for Sweden, that tight money actually increases debt burden (Fisher, Krugman/Eggertson argued in similar fashion). Its normal to have higher leverage if your expected income is collapsing and real expected debt burden is rising. Sweden is the prime example.

    Not saying there are no structural issues, but if the target is and has been 2% inflation for 2 decades, than it is legitimate to expect the CBs to produce 2% level. If CBs would do it, it would be enough. Than you will know that lower real growth is a result of structural shift/shock... Now you can't be sure how much is the rgdp affected by tight money and how much by the structural shock. In Woodfordian language it would mean "let the RBC core of the model" determine outcomes.


    1. Hi Petar, thanks for the comment and sorry for a rather late reply.
      Regarding your first question I would say that money was tight in Japan if we adhere to Friedman's arguments. However how would you define the "just right" amount of money to be pumped? How much is enough for Japan? Cause if you look at the graphs (see here) the money base expanded massively during the two decades in Japan, but actual bank lending decreased. Just like it's happening in Europe now (on average I believe). They too arguably had a low velocity of money in that period which was in my opinion probably due to low confidence. In Europe its mostly structural issues which prevent a recovery in the jobs market and in terms of business investment where businesses face a huge number of constraints in growing and hiring.
      Money is being pumped in (ok perhaps Europe's not the prime example, it's better to view this from the UK/US perspective), but the banks are still hoarding cash. So the question is how do you incentivise the banks to push the money into the real economy? Cause if the banks are well capitalized (but still in uncertainty of future regulatory requirements) then obviously monetary policy can pump as much as they want, it's not gonna help.
      That's why I believe the problem is on the supply side. If this were a demnad side shock, it would have already been solved with the monetary stimuli provided.

    2. Basically you can only gauge the "right" amount of base money by looking at (expected)NGDP or inflation. Inflation is of course bad indicator, but much better than interest rates or base/m1-2-3. "Just right" is what CB tells people it considers just right. It was around 2% CPI/PCE for years.

      Lending is unimportant - banks don't lend reserves (to clients) anyways. QE works trough different channels and it is essentially useless unless it is tied to a target and CB promises the base expansion will be permanent. QE3 isn't only buying stuff from banks, but banks do the selling for individual bond holders so they get deposits created, banks get reserves on the liability side of the balance sheet. ECB has exactly results it wants, and it actually only dealt with banks (LTRO). Banks don't need so much liquidity and they are reducing deposit facility balances. They aren't only agents in the economy.

      But my point is that demand for loans is low because low expected AD. This is also causing the tightening of the lending standards as ECB bank lending surveys have shown from 2008 to now on. I would call it, in plain new keynesian - the natural rate is below the policy rate. Every loan is too expensive. But this is similar to the debate we already did, I just needed your clarification of what you consider a good indicator for the stance of monetary policy :D

    3. Btw, here*s an interesting opinion how your "primary" field of research (as I understand) could explain the ZLB persistence:
      "The bitter truth is that central banks launch economies off the ZLB when politicians force them to. This was true of many economies in the 1930s, it seems like it will be true of Japan, and there is every indication that it will prove true of Europe and America. The ZLB is not an economic problem. It's not about deleveraging or inflation targets. It is a political problem. Preventing the kind of crisis and recovery is easy: just have a political majority committed to something different. That is, we need to think about who the big losers from the last few years have been and why the political system has not served them better. Is it because political power is distributed unequally? Is it because the losers are actually quite few in number? Something else? It's not a satisfying answer but it's ultimately the right one: things are not better because elected leaders did not feel pressure to deliver something better."

    4. Link:

    5. interesting point, thanks for the link.
      and yes, all of the above simply brings us back to our very interesting debate :)