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 ( is a senior research fellow at the Mercatus Center at George Mason University.

NEXT: The Inevitable Health Care Reform Letdown

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  1. Agree that inflation is already happening. My barometer is the price of a decent lunch, which is currently reaching $10. It’s virtually impossible to get lunch for $5.00 anymore. $7.00 is a squeeze.

    1. that’s a pretty loose barometer unless you go to the same place.

      1. Both of you are correct.

        The price of lunch is going up. It’s barely possible to get a sandwich, chips, and drink for $10. However:

        It’s not the same ham-sandwich-and-a-bowl-of-vegetable-soup lunch we’re eating these days. Many middle of the road lunch spots now offer such formerly exotic items as fresh mozzarella, swiss chard, arugula, lattes, etc.

        So, the price has gone up slightly, but the food quality and variety have increased a great deal. Either that or I’ve just been going to different lunch spots as I get older and develop better taste.

        1. same here…10 years ago subway…7 years ago Quiznos…4 years ago Sabastians.

        2. Fuck hedonics,how much is lunch again?

        3. I dunno, I find that the quality of “new” chains tends to objectively degrade over time. I don’t think it’s just my taste. I distinctly recall that when it first opened, the Olive Garden’s salads did not have kraft italian dressing on them, and did not contain only iceberg lettuce.

  2. Also, my feeling is that the gov’t may be juking the stats on inflation to try to inflate it’s way out of SS pension debt.

    1. There is no feeling about it, the government has been fudging inflation data for decades. Once way is by changing what is in the basket of goods they count, they start off with steak, then replace it with ground beef, then replace it with dog food and then declare that inflation is low.

      1. Yup

  3. [Inflation is] 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 reason you don’t see inflation reflected in an increase in overall prices is because banks and people are holding on to cash, but there is no question once that cash starts circulating, it will already be worth less than before the expansion.

    Questioning the existence of inflation because there has not been a general price increase is like telling a patient he does not have HIV because there are no obvious symptoms.

    1. Banks aren’t “holding onto” cash, they have it in interest bearing accounts like everyone else. The only difference is the interest the accounts earn is created out of thin air by the Fed.

      Instead of slowing down, the rate of money creation is speeding up as interest compounds in imaginary New York accounts.

      1. This is exactly right. What we are witnessing is the REAL bank bailouts (not TARP, which was a magician’s trick); the Fed lending program hands money to banks at zero interest, then the banks get to immediately turn around and (at no risk) deposit money with Fed and earn interest (which I can’t freaking get at my bank, unless you call .65 interest) and buy the long end of the yield curve at a few hundred basis point spread. Yes, they are printing money – and handing it to the banks.

        1. I know. Why aren’t the mass media point this out? Most of the money the bankers are “earning” is just the merry-go-round money that you are pointing out.

          A dead blind rotten monkey could make billions if he were allowed to get in on this scheme.

          1. “Why aren’t the mass media point this out?”

            The same reason the MSM isn’t pointing out that “health reform” is nothing but a giant ponzi scheme.

  4. Pacific Research Institute economist Robert [P] Murphy

    Not to mention he is also an adjust scholar at the Ludwig von Mises Institute, and a frequent contributor to, author of several books on economic history including the Politically Incorrect Guide to Capitalism, and the Politically Incorrect Guide to the Great Depression (highly recommended to you all.)

  5. You may want to put link to the figures referenced, (which were lost in transition from the dead tree edition) as well as links to some of the other references in the piece (particularly the blogs)

  6. th cash that they have pumped in is sitting on deposit at the federal reserve. general prices are not rising because that cash is not used to buy things that are on the general price list – instead it is left capitalizing banks against paper losses on exotic mortgage instruments and the like.

    The connection between deposits at the fed and price of lunch is definitely tenuous at best – which is why I always get on this board and caution the goldbug/strict austrians about equating inflation with monetary base expansion.

    1. Re: Domoarigato,

      The connection between deposits at the [FED] and [the] price of [a] lunch is definitely tenuous at best – which is why I always get on this board and caution the goldbug/strict austrians about equating inflation with monetary base expansion.

      You’re presenting a strawman argument if you are implying that Austrian economists argue that monetary expansion equals a higher price for “a lunch”. Austrians are fully aware that the expanded money has to circulate first in order for the symptoms to appear (in the form of increasingly higher prices for consumer goods, services and/or raw materials.)

      However, the economic phenomenon is explained as an continuous increase in the money supply – there is NO other theory that accounts for the general increase in prices.

    2. We haven’t seen much in the way of consumer price inflation, but one thing all that cash pumped in at the institutional level is doing is inflating asset prices worldwide. That cash is being used, directly or indirectly, to support equity prices and is driving prices in hard assets of all kinds.

      Real estate prices remain low in the US because they are driven more by the general economy – residential real estate prices are set by homeowners currently suffering from the recession, and commercial real estate prices are set by businesses, also currently suffering from the recession.

      Other hard assets? Running up in what may be the bubble du jour. The current stock market? Definitely a bubble.

      1. Real estate prices remain low in the US because they are driven more by the general economy –

        Real estate prices are not low. They are still nearly four times what they were in 1979, and only selling at some of the highest debt-to-down payment ratios in American history.

        Bernanke’s now on record as saying rez RE will see small growth later in 2010. Even if he can run the printing presses fast enough to make that prediction true, the trend that began in 2006 will be with us for a long time: Real estate prices want to keep falling.

        The people know it: That’s why the 2010 trailer was such a hit, because it spoke a truth nobody’s getting from the leaders or their media parrots: There’s nothing holding up those houses but dust and deluded hopes.

        1. In Tim We Trust. Very well said

        2. True enough, Tim. I was looking more at why they haven’t participated in the general bull market in hard assets (driven, I posit, by our current liquidity bubble).

          When the velocity of the money supply picks up, inflation will hit like a fucking steamroller. And I have yet to hear anyone give me a plausible explanation of how all that liquidity that has been thrown out of the helicopter will be vacuumed up to prevent inflation.

  7. I don’t think people assume TIPS investors are geniuses and gold investors are morons. The TIPS spread is certainly a purer measure of US inflation expectations. Gold prices reflect lots of other, international forces, including consumption.

  8. Expanding the monetary base IS inflation. Rising prices are an EFFECT of inflation, which always has some lag before they show up.


  9. The keynsian/pro-fed academics always cite TIPS securities as prrof that smart money doesn’t think inflation is coming. However, TIPS are not soley a bet on inflation, they are also a bet on the trustworthiness of the government in calculating the CPI portion of its coupon payment…this is really silly, because if you can’t trust the Fed to fulfill there mandate of protecting the value of the dollar(which we obviously can’t)….then why would we trust this secondary promise?! So where do people flee? precious metals, emerging markets etc.

  10. looking at TIPs to judge inflation expectations is like polling the DEA employees to judge the expected benefits of the drug war over the next 10 years.

  11. Old Mexican – see John C. Randolph’s comments for evidence that my post above is not merely me thrashing a strawman.

  12. nor am I particularly impressed by your spelling corrections. It’s true my spelling is terrible, but that’s because I spend my days modelling and trading inflation on a sticky bloomberg keyboard, not writing comments for websites.

  13. No one can tell me how the Fed paying interest on trillions of dollars will not translate into a massive spiraling obligation.

    Think about it, I’m a bank who sees no good lending opportunities. I give the money to the Fed, who will pay me a small amount of interest on the money. {Essentially, the banks are using the Fed the same way most people use savings accounts).

    Suddenly, a good business opportunity comes up that will pay me 5%. I want to get that money out of the Fed to make my 5%. Unfortunately for helicopter Ben, now all the banks want to take the money out to get theirs, risking the hyperinflation that is only being prevented by the Fed holding the money on their books.

    The ONLY WAY for the Fed to stop this exodus back into the lending market, doubling the base and triggering massive inflation, is to raise the interest rate it pays on accounts it holds.

    In turn, raising these interest rates will increase the amount of money the Fed is holding, forcing them to continually raise interest rates to hold money in there, resulting in more money in the accounts……into a spiral.

    Anyone who can explain how this will not happen wins an internet.

    1. There’s one other way the Fed can keep the money out of the market: raise the reserve requirements. The current requirements are 10%(!) for transaction deposits and 0% for time deposits. If the Fed increased the requirements to at least 50% (or more), bank deposits currently held by the Fed would still exist, but would be permanently out of circulation, as they would have to be held to back individual deposits. This would also help to relieve any potential burden on the FDIC. Don’t count on this happening, since banks and the government have long believed in prosperity through counterfeiting.

  14. In a finance/credit driven economy, I would think that M2 and M3 would be the tells on inflation…currently, they are on a donw trend (i.e., deflation)…just like most people’s housing values, stock portfolios (looking beyond the last 6 month’s of bubbling up)and wage prospects.

    I don;t know that CPI has ever been anything but a popularized gimmick for telling people something their first hand experience already confirms or denies. So while lunch may be more expensive, a new home certainly isn’t…if you can access credit to buy it.

  15. As the economy recovers and interest rates rise, the interest rates the Fed earns on its asset portfolio will rise, allowing them to pay higher interest on reserves.

    Of course, in reality, they will sell off those assets and collect on the loans they made to banks. The quantity of reserves will fall.

    Because the Fed does own some really bad assets, it could require a bailout from the Treasury. I don’t think that is likely, but it is possible.

  16. For the time being, the monetary seas are impossibly choppy, with

    the evaporation of trillions in third-order derivative assets,
    the destruction of trillions in stock and debt obligations,
    the injection of trillions of new liquidity,
    the dialing in of trillion-dollar deficits ad infinitum (which is also monetary policy, as a deficit is the same as printing money)
    the slow-motion collapse of the dollar as world reserve currency, etc.

    At the end of the day, though, there will be hell of a lot more dollars in circulation than there are now, so I think its not a question of if, but when, we get serious inflation.

  17. I don’t know for certain if you folks noticed, but about $10 trillion disappared in the stock market crash. Now, I’m an historian, poly sci major, J.D.-toting retired attorney, but I seem to remember that the crash would have – will have – did have to some extent a deflationary effect on the economy. Seems to me that at least some of that “paper loss” would translate into the loss of “real” money. Certainly ought to have produced deflationary effects. Has the stimulus money actualy expended caught up with that (approximate) $10 trillion yet? I don’t think so.

    The stimulus money – Obama’s, Bush’s, whoever’s – was an error, along the same lines as pouring water over your engine when the radiator’s empty, but it went – is going? will go? – somewhere, other than to pad the financial statements of the Wall Street buddies of the Republi-Crats. Or am I mistaken and all that money is really in my bank account??

  18. Government gives backs tens of billions for almost no interest. They turn around and buy government bonds, collecting a few percent. They then pay themselves big huge bonuses for being so damned smart.

    Where do I sign up for this racket?

  19. Why was the word “velocity” not even mentioned in this article?

    1. Because it wasn’t needed.

  20. The title of this article implied that it was going to teach us something about what’s going on. Instead all we got were lines like this

    The St. Lawrence University economist Steven Horwitz agrees both that inflation is already happening and that it is widely misunderstood.

    But this does absolutely nothing to clarify the misunderstanding.

    My gut instinct: if you can’t explain what the hell is going on right now, then you have zero hope of even guessing at what will come tomorrow.

    How much it costs for lunch depends a whole lotta lot on where you buy it. The popular mass market chains have gone up and down on both quality and cost, by my memory. And many of the restaurant chains have had financial problems in recent years anyway so they’re currently on a “costs more for less” binge.

    I was around in the late ’70’s. I remember what inflation was like. I don’t believe we’re seeing a whole lot of it going on right now.

    This article does nothing to convince me I’m wrong. It claims “well you’re just missing it”, without giving any measure or methods by which to not miss it.

    Before you can hope to gage the prospects of inflation tomorrow, you must first understand why we aren’t seeing it today — when we know they’ve created mountains of money out of thin air.

    Somehow I smell another trick going on under the waves, that we haven’t quite gotten our collective arms around yet. Maybe the Fed/Treasury has come up with some kind of new trick?

    The only other possible explanation is that inflation and deflation are in fact nearly balancing each other, to maintain (on average across the board) a relatively flat CPI, however you measure that.

    Which just might be what the new trick is, that they’ve figured out how to do just that. But it’s clear as mud to me what the long term impact will be.

  21. I’ll concede that part of the new trick may be paying banks interest to hold reserves. But while the government boys may not have our best interests in mind, they aren’t completely stupid.

    Inflation is a more or less slow death spiral. But the scenerios people paint of what happens down the road with the interest they’re paying the banks makes it sound like we avoid the spiral, in exchange for sudden death down the road.

    I can’t believe this hasn’t occurred to anyone in the government. They’ve got some kind of plan.

    Somehow I cannot escape the conclusion that the conventional wisdom on the street is still missing something about what’s going on. Something crucial.

  22. In my opinion, the best monetary base would be one that politicians and bankers and even economists can’t artificially manipulate. If they need to make the dollar stronger, they can build houses and grow food in their spare time. If they need to weaken the dollar they can use their private savings to pay people to dig and fill up holes. The only thing that should change the value of a dollar is the free marketplace. Precious metals are the way to go.

  23. But — but — how can you do social engineering this way? Our politicians HAVE to have their social engineering you know. How else would they ever manage to feel good about themselves?

  24. I am not sure what the trick is either…but tungsten bars coated in gold seems to have something to do with it.

  25. Cheers Mr. Scrooge. Thanks for pointing out my oversight. I didn’t even think about how many american jobs would be lost in the Social Engineering sector. I withdraw my suggestion as it has been brought to my attention that it would be a jobs killer.

  26. Maybe the increase in money supply injected into banks was offset by the hundreds of millions of dollars ejected out into imaginary and non-existing congressional districts?

  27. As I understand it, part of the reason for the bank bailouts is that the banks held lots of their reserve on the value of mortgage backed securities that became suspect and instantly worthless when the housing bubble burst. So if you had reserves of 10 billion based on market values of a collection of houses, and those houses suddenly loose 40% of their value then you have lost 4 Billion instantly. The reserve requirements are defined by Federal law. I read somewhere that just to fill the reserve hole is going to cost on the order of 12 trillion dollars. So the fact that they are still filling in this ‘hole’ (existence mandated by federal law but probably necessary for sound business practice) lending is still tight and not much is actually getting into circulation.

    Most likely the problem will become apparent once it reaches critical mass and banks start lending again, as some other readers noted above.

  28. As long as we keep an eye on a partial price index, like CPI is, while considering a wide monetary measure which we do not know where it does flow to (actually out of the restricted basket CPI refers to), we will keep misinterpreting the actual inflationary stance.

    Moreover: if prices should tend to lower, because of low-cost Asian contributions or general over-consumption retreatment, is not substantial stationarity of prices actually mere inflation?


  29. The monetary base has been inflated hugely, it’s just the deflation from all the destroyed credit that’s holding the damper on prices for the moment. That said, the dollar is being crushed and gold is rocketing.

    During the Great Depression when currencies were tied to gold, governments added tariffs to try to keep a damper on unemployment by making foreign goods more expensive. Today, with no gold and free trade, the same thing is being done via currencies which are only tied to a button in Ben Bernanke’s office.

    The true rate of inflation is almost 60%. That’s how much gold has risen (in dollars) since Obama’s election ($1190 from $750). Proving you can have deflation AND inflation at the same time. It’s all relative.

  30. My only point is that if you take the Bible straight, as I’m sure many of Reasons readers do, you will see a lot of the Old Testament stuff as absolutely insane. Even some cursory knowledge of Hebrew and doing some mathematics and logic will tell you that you really won’t get the full deal by just doing regular skill english reading for those books. In other words, there’s more to the books of the Bible than most will ever grasp. I’m not concerned that Mr. Crumb will go to hell or anything crazy like that! It’s just that he, like many types of religionists, seems to take it literally, take it straight…the Bible’s books were not written by straight laced divinity students in 3 piece suits who white wash religious beliefs as if God made them with clothes on.

  31. My only point is that if you take the Bible straight, as I’m sure many of Reasons readers do, you will see a lot of the Old Testament stuff as absolutely insane.

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  40. I’ll concede that part of the new trick may be paying banks interest to hold reserves. But while the government boys may not have our best interests in mind, they aren’t completely stupid.

    ???? ????? ?????? ??????? ???? ????? ????? ???????
    Inflation is a more or less slow death spiral. But the scenerios people paint of what happens down the road with the interest they’re paying the banks makes it sound like we avoid the spiral, in exchange for sudden death down the road.

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