Milton Friedman famously claimed that inflation is always and everywhere a monetary phenomenon. Later he clarified that he was referring to episodes of persistent inflation. In the short run, supply shocks can impact the price level.
Over the past decade, I’ve been arguing that trend RGDP growth has fallen to about 1.5%, mostly due to slower labor force growth (retiring boomers and fewer immigrants.) In that case, the Fed needs to generate roughly 3.5% NGDP growth to maintain its 2% inflation target.
The new GDP figures continue to show wildly excessive growth in nominal spending, with NGDP soaring at more than a 6.7% annual rate. (Please wake me up when the Fed begins its tight money policy.)
NGDP has grown by 19.2% over the past three years, whereas 10.9% growth would have been appropriate if the Fed were serious about maintaining a 2% average inflation rate. That extra 8% nominal GDP growth is 100% due to an overly expansionary monetary policy. Monetary policy cannot control aggregate supply, but it can control nominal spending.
This led me to investigate how much of our inflation problem was due to monetary policy, and how much was due to supply shocks. As of late 2021, part of the inflation problem was clearly due to supply problems. But how about today?
The most recent PCE inflation figures are for August 2022, and show the price level up 14% over the past three years. Notice that prices have risen by 8 percentage points more than would be appropriate under a 2% annual inflation target (which would be slightly above 6% over three years.) That’s identical to the excess NGDP growth. As of today, it’s all demand.
Friedman was right that persistent inflation is almost 100% a monetary phenomenon. But he was not right about the best way to identify a “monetary phenomenon”. Friedman focused on growth in the monetary aggregates, whereas many of us now believe that it is NGDP that best measures the stance of monetary policy.
Just as in the 1970s, demand side inflation has been misdiagnosed as supply side inflation. In the short run, supply shocks can indeed cause inflation to deviate from NGDP growth. But over the longer run, inflation is almost entirely driven by aggregate demand, i.e., by growth in nominal spending.
It’s the NGDP, stupid.
PS. In fairness to Friedman, the M2 money supply is up 41.6% over the past three years. So while not all inflations are caused by rapid money growth, this one is. Indeed velocity has actually slowed during this period, which means that more than 100% of the inflation comes from monetary policy as defined by Friedman. Thus, at least this time around:
It’s the money supply, stupid.
PPS. A few months back, I criticized a Robert Barro claim that we can be “highly confident” that the US entered a recession in early 2022. Today’s data effectively eliminates that possibility. (Something we already knew from many other indicators.) We may enter a recession soon (they are hard to predict), but we almost certainly weren’t in one in early 2022. Please reread my earlier post if you wish to learn why Barro made that mistake.
