Money supply inflation vs. price inflation

Reader Don Lloyd writes on the differences the between money supply inflation and price inflation, and why the former may not always reflect in the latter as measured by arbitrary indices such as the CPI.

In spite of all of the Austrian school's best efforts, most economists and other people refuse to believe in the reality of 'inflation' unless it shows up in the CPI or other similar indicators, no matter how much of an increase in the supply of money is admitted to.

The response of most people is to talk about 'asset inflation', which sounds unconvincing, even when true.

This causes two or more problems.

First, it allows the FED to claim that it has not been a reckless monetary inflator unless and until it shows up in the CPI. This is analogous to a reckless driver disclaiming responsibility for his driving by pointing to his rear bumper and noting its unmarked condition even though the front end of his car is a crumpled mess now two feet shorter than when it left the factory.

Secondly, it tends to seem to undermine the Austrian explanation of the 1920's boom/bust cycle since CPI measures did not reflect the monetary supply inflation that was present.

It seems to me that the conceptual problem is that no attempt is generally made to distinguish between different distinct possible monetary inflation supply mechanisms and their possible distinct effects when they initially dump supply on distinct individuals with tastes for different products with different distinguishable characteristics.

As an example, if the FED increased the money supply by passing out new $100 bills at the entrances of fast food restaurants, it wouldn't be hard to imagine that the products that showed the largest and earliest price inflation would be fast food itself, and then beef, for example.

Alternately, if the new $100 bills were distributed to Orthodox Jewish neighborhoods, it would likely be kosher products of all kinds that would show the earliest and largest price inflation.

In reality, the money supply is increased by creating new bank credit and loans, both for businesses and individuals. The impact of this form of increased monetary supply is far from uniform in its effects on products and the individuals that buy them. If you don't take out a new bank loan, you will not be an early participant in the bidding up of the products that YOU buy. Similarly, products that aren't bought mostly on credit will not tend to be among the earliest and most affected products.

But money supply is only part of the equation. For every product, its market price will depend on the following --

1. Specific product demand from its potential purchasers.

2. Specific product supply from its suppliers.

3. Money demand to hold from the potential purchasers of the product.

4. Money supply held by the potential purchasers of the product.

5. The competing demand for all other products from its potential purchasers.

6. The competing supply of all other goods and services from their suppliers.

The significance of all this is that products that may be similar in their relationship to an increased supply of bank credit may well respond differently in price due to other factors as above.

Some hopefully illustrative examples --

Housing and real estate

This would be expected, under normal conditions, to be an area where prices respond relatively quickly and intensively to increased bank credit, the mechanism of increased money supply that is actually used. People who buy houses almost always do so through bank credit, and they will generally do so at times at which they are not demonstrating a demand for money to hold. They obviously have a demand for the house, and the supply of land and houses is often rather limited. All of these factors, money supply high, money demand to hold low, house supply low, house demand high, tend to drive the prices of houses up. In addition, houses and all other forms of goods that provide their services in an extended future, are valued higher in the present when the rate that discounts their future value back to the present is lower. This lower interest rate is exactly what results when the supply of loanable bank funds is increased.

It is clear that the prices of most houses and real estate have gone significantly higher in the recent past, largely, I am conjecturing, in response to increased bank credit, and the associated reduction in interest rates.

Cars and trucks

As with houses, cars and trucks of all kinds are usually purchased with bank credit, although less intensely. Using the same reasoning, increased bank credit should be a factor that tends to increase prices. Also, cars and trucks see higher current values due to lower discount rates of their future service, as with any durable good. This also applies to equities and capital goods.

However, without even looking for data, I am confident that there has been little if any price increases in the recent past. The obvious explanation is a large supply of cars and trucks, both from domestic and foreign suppliers, that more than offsets the increase in bank credit.

Common consumer goods

For example, a $25 table lamp sold in Walmart. This would not normally be purchased with new bank credit, especially if Walmart customers have maxed out their credit cards, to the extent that they have them. Nor would we expect them to have a large demand for money to hold, at least not a demand that they can satisfy. The consumer demand for this product would not be expected to be especially intense, and the supply of product from Walmart's Chinese suppliers would be as large as necessary. All of these factors tend to lead one to expect that Walmart table lamps, and many other common consumer products, should show little or no price increases in response to increased bank credit.

Every product has its own circumstances that will help determine the sensitivity and timing of its price to an increase in bank credit.

Summary

To the extent that CPI-type measures of prices are weighted heavily to common consumer products, it is a near certainty that they will not adequately serve as a timely measure of the damage that monetary inflation through increased bank credit will cause.

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Don, If I understand you

Don,

If I understand you correctly, the basic thrust of your post is that there is no way the complete effect of money supply inflation can be measured by price indices, because:

1)No index can measure the totality of goods effected due to the always finite number of goods in any 'basket'.

2)Since money supply is only one factor among many that contributes to the price of any good, price is not always effected by changes in money supply, and thus is an imperfect indirect measure of the effects of money supply inflation.

(Just for reference for others, this is the Bureau of Labor Statistics page that describes the CPI: link)

Lots of good points about

Lots of good points about the CPI's problems.
My two cents... Austrians' sermon is "Fed is wrong", "Fed is printing money", "Inflation will eat us". Granted, the fed indeed is printing money. But what about the demand for money. If the world's economy demands USD faster than the Fed prints it than we have deflation.

I am currently shopping for a home myself. And have spent quite a bit of time worrying about whether prices are being driven solely/mostly/
greatly/somewhat by the low interest rates.

What have I concluded. Lower interest rates are contributing to house prices (duh), but are not the major contributor. Other issues are investment alternatives, the stock market (until recently) has been crap, a home is a real asset. People are buying homes as an investment. Also demographics, there are a huge number of 30-somethings (myself included) looking for homes. From what I have read is that home buying patterns are well correlated with age. Buy your first home 30's, upgrade 40's, second/vacation 50's, down-size 60's.

Also, lets not be so quick to equate interest rates or money borrowed and money supply. Mises wrote about this, right? Money supply does not equal debt.

I don't think we have to

I don't think we have to worry that there is demand for dollars. The exchange rate of dollars against many other currencies over the past year indicates that many people are valuing dollars less than other currencies.

The Austrian scenario of what happens when a central planner sets the price of a good too low matches what is happening here. In this case the good is credit. We don't know whether it is some other more complex interactions or not, but using Occam's razor is usually correct.

I was not very clear. I'm

I was not very clear. I'm not suggesting we are currently experiencing deflation. But the dollar had been appreciating against everything since ~1996 (if I remem correctly). Its ammusing to see it getting so much attention so late in the game, especially after recent devaluation of USD.

With this devaluation what should have happened? Commodoties increased, commodities producers making more money, companies that service commodities doing better. What have we seen? Commodities recovering from a multi-year slump, companies like John Deere beating estimates, countries like Thailand (heavily dependent on commodities) posting larger GDP growth. It'll take some time for these price changes to filter through the economy but you are not going to be seeing more sales going forward. We'll probably start to see a modest uptick in the CPI 1-2 years from now (btw, that time table is straight out of my ass).

I'm not suggesting we are

I'm not suggesting we are currently experiencing deflation. But the dollar had been appreciating against everything since ~1996

Which is the opposite of what I've seen. I saw wage inflation, equity market inflation(NASDAQ especially), housing inflation (shortages in SF and Berkeley), even the prices of basic foods were heading up. But, that was near the center of the last round of malinvestment, the Silicon Valley. Seeing such differences points to yet another bit of Austrian wisdom, the situation at one time and place is different than any other time and place. Which makes indexes such as the CPI look even more silly.

We'll probably start to see a modest uptick in the CPI 1-2 years from now (btw, that time table is straight out of my ass).

While we're pulling guesses out of our posterior regions, I am guessing quarterly CPI bouncing around between -0.5 and +2.0 annualized for the next few years.

Jonathan, Grant and

Jonathan, Grant and Dave,

The FED primarily exists in order to increase the money supply in the mistaken belief that it can somehow yield benefits that outweigh the damages. In doing so it must have a means to calibrate the amount of increase that it provides. This means is essentially the CPI. The essential mismatch of the CPI and the increase of bank credit, in both degree and time, means that the FED will nearly always increase bank credit beyond its intent, even assuming that the intent was a good idea in the first place.

It is true that money supply doesn't equal debt, BUT the debts that result from added bank credit ARE an unstable part of the money supply.

I have not ignored the demand for money at all, but but all that means is that an increase in the demand for money results in a higher level of supply inflation required to produce the same results. The FED can only respond to results, as useless for control as those results may be.

Regards, Don

The FED primarily exists in

The FED primarily exists in order to increase the money supply in the mistaken belief that it...

I thought the Fed (and all central banks) exists to benefit certain politically connected businessmen.

Anyway, great post Don.

Increases in housing prices,

Increases in housing prices, fruit, oil, cars, software engineer salaries is not the same thing as inflation. Prices move for other reasons than monetary inflation. Such as too much rain in the NE is bad for local crops. Lots of wealthy people all wanting to live in the same area pushes up prices.

To get a guage of monetary inflation you can take a look at commodities. Currencies are not a bad guage although since all ccys are fiat you have to take into account what the other central banks' policies are at that moment. Some commodities are a good guage, oil is not so good because there is not a constant stock and it has many industrial uses. Gold is a good indicator. The gold stock is very stable and expands at an approximate 3% per year. While gold is used in some industrial applications they are very minor. Other metals are also a good guage but not as good as gold, they tend to have more industrial uses.

I don't understand what you mean by "unstable part of the money supply" or "increase in the demand for money results in a higher level of supply inflation required to produce the same results". What I remem from Mises is that debt and money supply are not the same thing. So increases in debt may cause a cash crunch in the future as folks scramble to get their hands on USD to pay their debts. But that would cause a drop in prices as demand for money increases vs all goods and services. The easy credit can bring about lots of malinvestment but the credit will not cause monetary inflation, right? When the bills come due and all those bad investments start to fail there will be pressure to inflate the currency, benefiting debtors at the expense of lenders. I guess you can argue that that is exactly what we have just been through. Lots of malinvestment a few years back had brought on increased demands on money to pay those debts, that is why you saw gold/commodities fall only to recover late last year. Its not clear if the USD devaluation is a result of Fed intervention or events in the US and world pushing demand for USD down. Some folks have floated the idea that it was a flight to EUR, but EUR only appreciated against the USD not against all other ccys. So that would point the finger at a local phenomenon.

Grant, "...Prices move for

Grant,

"...Prices move for other reasons than monetary inflation...."

Absolutely. Back in my original post I provided a numbered list of the six items that determine the market prices of goods expressed in money. All of the possible causes of changes in the prices of goods fall into one or more of these six categories without exception.

"...Some commodities are a good guage, oil is not so good because there is not a constant stock and it has many industrial uses. Gold is a good indicator...."

You're wrong on gold being a good indicator.

As long as significant amounts of gold are held by governments or other organizations whose actions are not the result of a self-interested profit and loss motive, they can act as an effective gold mine with a zero marginal cost of production as they employ their gold to pursue political ends.

"I don't understand what you mean by "unstable part of the money supply" or "increase in the demand for money results in a higher level of supply inflation required to produce the same results"."

When banks make new loans to businesses or individuals the visible result can be a new funded checking account. Checks drawn on this account are almost completely equivalent to money and these accounts are certainly part of the money supply, sufficiently broadly defined, and will tend to bid prices up as well as any other form of money. They are unstable because the possible insolvency of the borrowers will result in a effective contraction of the money supply as the new fractional reserve loans disappear back into thin air.

When an increased demand for money temporarily prevents increases in prices as it offsets the effect of an increased supply of money, it will not permanently prevent price increases if, as is usually the case, the FED will not stop inflating the money supply until it actually sees the price increases.

Regards, Don

The gold held by CB is just

The gold held by CB is just that, just sitting there. Until the CB decides to sell it like BOE was doing recently. About 1/3 of the world's gold is in CB reserves, 1/3 is in private hands (sitting in a clearinghouse in london probably), 1/3 is in jewelry. So basically 2/3 of the world's gold is in private hands.

Most CB simply sit on their reserves with no legislative mandate to maintain a particular reserve ratio. Basically, the actions of gov'ts have very little to do with the price of gold (just a marginally educated guess). Intervention by CBs in the gold market?

Loans made by banks and deposited into bank accounts are not money (as Mises described it) they are money substitutes. I can use it like money to bid on assets. If I default on the debt, does not destroy money, the money is still there its just not with me. It demonstrates that I was unable to steer money in my direction vs everybody else competing for that flow. If I created an unrecoverable liability for my lender they will fail. Bank run.

Definitely the line is very blury when discussing money substitutes and fiat currency, but there is a difference. As you say "almost completely equivalent". Especially, in today's world with credit used so commonly in the smallest transactions (credit cards, debit cards) it is very easy to ignore the line. At least for me it has been helpful to keep the distinction in mind.

Cheers.

Grant, "...Loans made by

Grant,

"...Loans made by banks and deposited into bank accounts are not money (as Mises described it) they are money substitutes...."

See Human Action, Chapter XVII, Indirect Exchange, 11. The Money Substitutes

There are two forms of money substitutes at issue here, money certificates and fiduciary media.

The difference is that a money certificate simply represents money held in reserve by the bank. Fiduciary media are all the additional banknotes or checks or whatever beyond what has a reserve.

They are indistinguishable in the market and only the unbacked fiduciary media are an increase in the money supply.

Regards, Don

Grant, "The gold held by CB

Grant,

"The gold held by CB is just that, just sitting there. Until the CB decides to sell it like BOE was doing recently...."

Switzerland and possibly other countries as well, are in a gold selling mood.

However, since prices are determined on the margin even relatively small sales are significant. Also, just the threat of country sales is usually enough to scare off speculative buyers. Additionally, the gold doesn't really just sit there, but is often loaned out in place to short sellers operating on the futures markets.

Regards, Don

Thanks, I'll check Human

Thanks, I'll check Human Action.

Selling of gold by the CB's affects the price at the margin. No doubt. But how is the CB's selling manipulation? Under the Washington Agreement on Gold the CB's are limited to selling 2000 tonnes over 5 years (expiring 2004). Annual production is ~2600 tonnes. While at any given moment gold is impacted by buyers and sellers as everything. The longer trend washes out that noise.

Grant, "Selling of gold by

Grant,

"Selling of gold by the CB's affects the price at the margin. No doubt. But how is the CB's selling manipulation?..."

You were the one who used the word 'manipulation'.

It is in the strong self interest of incumbent politicians that the existing national fiat money is not seen to be starting to approach its certain final value of zero on their watch.

To prevent this, while not giving up all the political advantages of monetary inflation, the effects of the monetary inflation must be hidden from the public. After the official measures of price inflation have been deliberately corrupted by illogical and invalid statistical adjustments, the only credible signal that remains available to the public is the price of gold. It presents little difficulty or effort to effectively cap the money price of gold by mere unverifiable rumors of threats to sell CB gold.

Regards, Don

Didn't mean to put words in

Didn't mean to put words in your mouth. Sorry about that.

There is no explicit threat to sell gold. While it may be implied it is stretching the verifiable to say that. You don't need a charade to convince people that the fiat money is worth more than its commodity value. Our current regime of fiat ccy is not unique. People see the effectiveness of their money everyday when they walk into starbucks. If you had a strong enough state people would use coconuts as a medium of exchange, but paper is so much easier.

As far as "deliberately corrupted" seems to be overstating it a bit. Economics is not a hard science and the folks making up those numbers are doing the best they can with the theory-du-jour. Glorified weather men. Present company excluded.

Grant, "There is no explicit

Grant,

"There is no explicit threat to sell gold."

Capability must always be taken into account as a potential threat.

"You don't need a charade to convince people that the fiat money is worth more than its commodity value. Our current regime of fiat ccy is not unique. People see the effectiveness of their money everyday when they walk into starbucks."

The primary risk in fiat money is its loss of purchasing power over extended time. This doesn't necessarily have anything to do with its current day to day acceptability as a medium of exchange.

"Economics is not a hard science and the folks making up those numbers are doing the best they can with the theory-du-jour."

If it's not hard, why do almost all economists come up with different answers? ;) (yes, I know, hard-science)

Under an only slightly caricatured version of the hedonic pricing theory, if this year's electric can opener opens a can in two seconds as opposed to four seconds last year, there has been no price inflation even if the price has doubled.

Regards, Don

In Paul A. Samuelson's

In Paul A. Samuelson's chapter "Prices and Money" in his book "Economics" (10th edition, 1976), he mentions the equation P = (V/Q)M, where P is Price, V is Velocity, Q is Quantity of goods and services, and M is Money supply. V is calculated as GNP/M1.

Does this modified crude quantity theory stand the test of time? How can Q be measured? Would it explain the difference between the money supply and the CPI?

Tom, Both Mises and Rothbard

Tom,

Both Mises and Rothbard reject the 'Equation of Exchange' as a useless truism at best.

See --
http://www.mises.org/humanaction/chap17sec2.asp

"...On a market there are only individuals or groups of individuals acting in concert. What motivate these actors are their own concerns, not those of the whole market economy. If there is any sense in such notions as volume of trade and velocity of circulation, then they refer to the resultant of the individuals' actions. It is not permissible to resort to these notions in order to explain the actions of the individuals...."

"...The equation of exchange is incompatible with the fundamental principles of economic thought...."

Regards, Don

Don, From what I've read so

Don,

From what I've read so far, I can see that individual decisions can affect prices differently in different parts of the economy.

At the same time, I see a correlation between money supply and overall prices from 1945-1980.

In the 1980s, inflation was apparently brought under control, even though the currency supply continued to increase. How would you explain this?

I don't think it was velocity, because, if anything, higher velocity would have raised prices. What velocity might explain is the GDP growing faster than the money supply.

Tom

Tom, "...In the 1980s,

Tom,

"...In the 1980s, inflation was apparently brought under control, even though the currency supply continued to increase. How would you explain this?..."

Back in my original post you can find a list of 6 general items numbered 1 to 6 which together determine the prices of all goods.

While an increase in the money supply will generally be a factor that tends to increase prices, depending on the balance of the supply and demand for both goods and money, actual prices may either rise or fall, at various rates.

Without bothering to check, it is almost certain that the rate of increase of the supply of money in the 1980s was held to be significantly smaller than in the 1970s, largely in reaction to the near disastrous price inflation of the previous period.

Regards, Don

I see a slowdown in the

I see a slowdown in the growth of M3, followed by M2, and M1, but it occurs in the 1990s, not the 80s.

Tom, "I see a slowdown in

Tom,

"I see a slowdown in the growth of M3, followed by M2, and M1, but it occurs in the 1990s, not the 80s."

Since the most significant part of the growth in the money supply consists of fractional reserve bank credit expansion, just looking at the growth rate of M3 without simultaneously looking at interest rates will be misleading. A given rate of money supply growth will produce effects that are enhanced by lower interest rates and retarded by higher interest rates.

At the tail end of the 1970s, and into the early 1980s, the back of inflationary expectations was broken by the FED allowing the FED Funds rate to reach as high as the region of 20% or so, without reducing the growth rate of M3.

The growth rate of M3 seems to have taken its first step down around the time of the 1987 stock market crash, possibly helping to precipitate it.

The next step down was taken in about 1990, and was likely associated with the mild recession that helped to elect Clinton over Bush I in 1992.

The growth rate of M3 started back up in 1995 and, following two previous years of suppressed interest rates, resulted in the stock market bubble and crash that followed.

Regards, Don

I noticed that somebody

I noticed that somebody justified inflation, so long as it is to accommodate "market demand." Well, there is a market demand for murder, but does that make murder right?

Really, think about inflation more. Inflation is a euphemism for tax. Inflation is feudalistic in nature - i.e., benefits one AT THE INVOLUNTARY EXPENSE OF ANOTHER. Are you telling me that debasing the currency at the INVOLUNTARY EXPENSE OF ANOTHER is good for the inflation-payer?

See, in the free market if somebody demands money, they must EARN/PURCHASE the money.

And by the way, since inflation is only causal factor of prices, that is a VERY HUGE reason why the CPI is meaningless. Air, which is super abundant, is free. Does this mean that we haven't had inflation since air is free? The CPI does not capture things like marginal utility and supply/demand.

Another huge reason why looking at prices of particular transactions is because it doesn't tell you about real prices or real costs. The government gives out billions in subsidies to agriculture. Therefore, you may pay $X for subsidized milk at the grocery store, but you actually paid much more for the milk through the tax-and-expenditure process. I would take the CPI more seriously if it included taxes. But there is even a problem with including taxes, since, thanks to inflation, it is impossible to see who the real net taxpayers are.

Actually, the GDP is a far better measurement of inflation than the CPI. The GDP does not really measure economic growth.

Correction: I meant that

Correction: I meant that inflation is NOT the only causal factor of prices.