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Alexander William Salter: Against Inflation Revisionism

Monetary policy, not supply chains or fiscal policy, primarily drove inflation. We live in an era of inflation revisionism. Commentators blame recent inflation on everything except loose money, and they credit recent disinflation to everything except tight money. According to the new thinking, supply-chain improvements explain why inflation moderated. And explosive fiscal policy, rather than monetary policy, is why it shot up in the first place.

Both of these stories have serious problems. When you go to the data, the numbers just don't add up. Monetary policy is still the prime mover.

Economists agree about the fundamental cause of inflation: aggregate demand (total dollar-valued spending) growing faster than aggregate supply (total production of real goods and services). You get inflation when too much money chases too few goods. The disagreements are about why aggregate demand grew so quickly and how much aggregate-supply improvements matter for slowed inflation.

From the equation of exchange, we know that the growth rate of effective money expenditure (gM + gV, the growth rate of the money supply plus the growth rate of money's turnover) must equal the growth rate of dollar-valued spending throughout the economy (gP + gy, the growth rate of the price level plus the growth rate of real income). This is an accounting identity, meaning it's true by construction. It doesn't tell us about causal mechanisms in the economy. But it does help us categorize the effects on the relevant variables. Since gP is, by definition, inflation, and gy is the growth rate of real output, it follows that 1 percent faster real growth comes with 1 percent slower inflation. Hence supply-side disinflation is possible. But did it happen in this case?

Consumer price inflation peaked at 9 percent in June 2022. At that time, real GDP was growing at roughly 1.8 percent. Inflation slowed to 3.2 percent last month. The Q3 2023 real GDP data, the most recent we have, says the economy is growing at nearly 3.1 percent. In other words, we've had 5.8 percentage points of disinflation and 1.3 percentage points of faster real GDP growth.

But remember, the supply-side calculation of disinflation is that inflation falls one-for-one with output growth. But here we have 4.5 percentage points (5.8 − 1.3) of disinflation that can't be accounted for on the supply side. These are rudimentary calculations, but the arithmetic nonetheless suggests the demand side has been more important.

Let's move on to fiscal policy. It's true there was a giant fiscal stimulus during the Covid years. But there was also a massive monetary stimulus. Which one mattered more? We have strong reasons to think fiscal expansion changes the distribution of spending.

But we don't have strong reasons to think fiscal expansion markedly increases the total volume of spending, which is what you'd need for an aggregate demand increase. If Uncle Sam consumes more, someone else must consume less. The effects on total spending are small. Ultimately, the reason the Covid relief checks boosted aggregate demand is because they were largely financed by money creation.

Total deficit spending increased by about $6 trillion during the Covid years. At the same time, the Fed added about $3.3 trillion in government bonds to its balance sheet. Fiscal policy-makers undoubtedly put the Fed in a tricky situation with their blowout spending, but it was the Fed's decision to monetize 55 percent of the debt they incurred.

Economic history furnishes us with plenty of reasons to be skeptical that deficits alone cause inflation. In 1981, when President Reagan was sworn in, the budget deficit was 2.5 percent of GDP. By 1983, it had more than doubled to 5.7 percent. What happened to inflation over that period? It fell from 11.8 percent to 3.7 percent. That's a sharp disinflation off of a ballooning deficit. The reason is obvious: Fed Chairman Paul Volcker was in the midst of his now-celebrated monetary tightening, which broke the inflationary fever. Monetary policy, not fiscal policy, is the final determiner of aggregate demand.

To inflation revisionism, we can add the unfortunate resurgence of naive Phillips-curve thinking (the belief that there's a controllable tradeoff between inflation and unemployment), the over-reliance on interest rates as the transmission mechanism for monetary policy, and the trivialization of supply-side growth for wealth and wellbeing. All stem from the same error: failing to recognize the monetary determinants of aggregate demand and the real productive determinants of aggregate supply.

Strong labor markets don't cause price hikes because the Phillips curve is bunk. Economic growth is indeed disinflationary, all else equal. And interest rates are best understood as a barometer of monetary policy, rather than the main transmission mechanism. All of these insights are compatible with a monetarist view of inflation. If we want to rein in the Fed and stop perpetual deficit spending, we need to clearly identify which government entities are responsible for which problems. The basic problem remains as it always was: Congress and the president misallocate resources, while the Fed cheapens the dollar.

Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU's Free Market Institute, a Sound Money Project senior fellow, and a Young Voices senior contributor.

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Posted: March 27, 2024 Wednesday 06:30 AM