Where's That Inflation?

The monetary base has ballooned, yet inflation remains far off. Or does it?


From September 2008 to September 2009, the Federal Reserve pumped an unprecedented $2 trillion into the financial system by buying Treasury bonds and assets from banks. According to most mainstream economists, such action should create a general increase in prices.

Inflation is the result of more dollars chasing the same number of (or fewer) goods. As the Nobel laureate Milton Friedman put it, in one of his main contributions to "monetarist" economics, inflation is always and everywhere a monetary phenomenon—that is, it's caused by an expansion in the supply of money or credit. So why haven't we seen inflation in 2009? Are we looking in the wrong places, or is it time to update monetarist theory?

The monetary base, which consists of currency in circulation plus bank reserves on deposit with the Federal Reserve, has exploded, as Figure 1 shows. Figure 2, by contrast, shows inflation as gauged by the consumer price index (CPI)—the cost of goods purchased by the average U.S. household—and by a measure called the median CPI. Standard CPI is the traditional measure for inflation, but a few extreme outliers (such as the price of fuel) can throw off the average; thus the median is a more robust statistic to estimate the central tendency in the data.

So while the standard CPI shows deflation over the past year, that stems from a few anomalous sectors, such as energy, where prices have dipped significantly since 2008. The median CPI, on the other hand, shows an inflation rate that does not look very unusual.

The standard explanation for the lack of inflation is that banks are sitting on all that new cash. As soon as the economy shows signs of recovery, goes the theory, banks will make more loans, and the broader monetary aggregates will shoot up rapidly. But that expectation ignores an important factor: Beginning in October 2008, for the first time in history, the Federal Reserve started paying interest on reserves held by banks. So even when the economy starts heating up, banks will have an incentive to hold money rather than lend it.

What's more, should inflation rear its head anytime soon, the Fed could suck the newly created money out of the banking system by selling assets, such as some of the higher-quality mortgage-backed securities it bought from banks at the depth of the financial crisis. That would decrease the amount of money in the system and choke back inflation.

On top of that, the Georgetown University  economist Donald Marron has argued, if investors really thought we were on the verge of inflation, we would see the 10-year Treasury or 30-year mortgage rates go through the roof. But that hasn't happened.

Marron's view reflects what might be called the monetarist consensus. It is embraced by economists across the political spectrum, including Obama's economic adviser Larry Summers and the current and former Fed chairmen. It is a position that relies on the wisdom of politically independent (and hopefully monetarist) central bankers to manage both the economy and the threat of inflation.

Besides placing undue faith in the Fed's ability to time perfectly any necessary anti-inflationary measures, the consensus suggests that the nation's central bank now has the heretofore undiscovered ability to increase the money supply without creating inflation. If true, this would be an important new development, since inflation has long been rightly vilified for destroying entrepreneurship and long-term economic growth. But if false, this conceit could prove dangerous indeed. And it's probably false.

On his blog Free Advice in September, the Pacific Research Institute economist Robert Murphy argued that inflation is already here but economists are missing the signs. "From [December 2008] until August 2009, the unadjusted CPI level has increased 2.7%, which translates to an annualized increase of just over 4%," Murphy wrote. He acknowledged that "ten-year yields [on Treasury bonds] are…low" but added that the price of gold has increased enormously. "Why do we assume that TIPS [Treasury Inflation-Protected Securities] traders are genius forecasters, but gold traders are morons?" he asked.

In an email message, Murphy adds: "I believe we are currently witnessing a bubble in Treasury debt. I consider the current yields on 10-year U.S. government bonds to be absurdly low, just like the price of housing was absurdly high in early 2006. After this bubble bursts, investors will slap themselves on the forehead and say, 'What were we thinking? Why did we rush into Treasurys even as the government told us it was planning to double the federal debt burden in a decade?'?"

The St. Lawrence University economist Steven Horwitz agrees both that inflation is already happening and that it is widely misunderstood. Monetarists, he says, were "too focused on aggregates like 'the' price level, which led economists to ignore the way inflation could distort individual prices at the microeconomic level, causing resource misallocation in the process." Virtually all economists now agree, for example, that the Fed's low interest rates inflated housing prices earlier in the decade. Yet as the prices of houses went up, few economists worried about inflation because the CPI looked relatively stable, due in part to a decrease in energy prices. When housing started to crash in 2007, many economists thought the Fed should inject still more funds into the system to stave off further declines. They failed to see that the Fed had distorted relative prices in the first place.

As the George Mason University economist Peter Boettke explains, "A problem with the current monetarists is that while they learned from Friedman the idea that we should fight inflation, in practice they learned from his writings on the Great Depression that central banks should fear deflation." As a result, economists who are theoretically inflation-hating Friedmanites now want to meet every downturn by fighting deflation.

Because of this tendency, bursting government-created bubbles leads to the creation of new ones. The real lesson may be that inflation is not only a monetary phenomenon but also a political one. Which makes it that much more difficult to predict, much less control.

Contributing Editor Veronique de Rugy (vderugy@gmu.edu) is a senior research fellow at the Mercatus Center at George Mason University.