Opinion – Martin Wolf: Inflation rises and monetarists are fulfilled

“Inflation is always, and everywhere, a monetary phenomenon.” Milton Friedman made this comment in 1963. At the time, few macroeconomists agreed. Twenty years later, a large proportion of them agreed. Twenty years after that, the majority again disagreed. Today, nearly two more decades later, economists have to get serious about money again. If money is ignored, it will take revenge. As Bridgewater’s Ray Dalio recently asked, “Where’s the understanding of history and common sense about the amount of money and credit and the amount of inflation?”

The idea that there is a link between the money supply and inflation is a very old one. When people have more money than they want, they will want to get rid of it. With any other good, this would lower its price. But the nominal price of money is fixed: a dollar is a dollar. Adjustment comes through price hikes for everything else — or inflation.

After an exceptional monetary expansion in 2020, we are certainly seeing this. I mentioned this possibility in May of that year. Tim Congdon, a well-known monetarist, had stated this before. According to the Center for Financial Stability, the “Divisia M4” (an index that weighs components by their role in transactions) grew 30% in the year to July 2020, almost three times as fast as any similar period since 1967. after the 2008 financial crisis. Many were concerned at the time with the expansion of the monetary base. But that didn’t matter because it didn’t affect the broader aggregates.

A big lesson from history is that if economists think they understand how macroeconomics works, they are wrong. In the 1930s, the conventional wisdom was that the economy stabilized itself. In the 1960s, expectations of inflation and money didn’t matter. In the 1980s, it was only money that mattered. In 2000, that credit expansion would not destabilize the financial system. In 2020, that money was irrelevant. Over and over again we fall in love with naive stories. We want to believe that the economy is a simple mechanism, but it is not.

In 1975, British economist Charles Goodhart asserted that “any observed statistical regularity will tend to break down when pressure is imposed on it for reasons of control.” His view was applied to the failure of monetarism to drive the economy. But Friedman would not have been surprised. He had claimed that money affected the economy with “a delay that is both long and variable.” But he didn’t believe in running the economy. Those he believed in, instead, went on to drive inflation.

But “Goodhart’s law” has a plausible corollary: when a measure ceases to be a target, it becomes meaningful again. As Mervyn King, former governor of the Bank of England, commented in an important recent lecture: “Money has disappeared from modern models of inflation.” This is ridiculous. So why did it happen? It is because technocrats have a foolish tendency to prefer being exactly wrong to being approximately right.

So where are we today? Optimists claim that the inflation we are seeing is just the result of temporary shortages caused by the pandemic. This is indeed part of the story, as a recent IMF paper explains. But the need, he says, is “to sustain a still incomplete recovery and ensure that production follows its pre-pandemic trend — without allowing wages and prices to spiral upward.” Really. The difficulty is that, as Robin Brooks of the International Institute of Finance has shown, inflation has become general: in the United States, the weight of articles with price increases above 2% in the year to January 2022 was just below 90% in the index.

To make matters worse, Alex Domash and Lawrence Summers argue that measures that show a very tight US labor market, such as vacancy and layoff rates, are better indicators of inflationary pressures than non-employment. Worse, the rigidity of the current labor market would previously have been associated with unemployment below 2%.

In short, the inflationary genie has come out of the bottle, especially in the United States. The danger is that this triggers a spiral, in which inflation expectations shift upwards, causing money to flee and thus further destabilizing expectations. There is no point in insisting that this will not happen, because it clearly can do so when inflation is so far above target and previous forecasts. Credibility will have to be preserved anyway.

What that means in politics today is quite difficult. But, as King powerfully asserts, central bankers also need to reconsider some of their recent doctrines. Just as the financial crisis showed that the banking system matters, this high inflation shows that money matters. It also indicates that future guidance presupposes more knowledge than anyone has. Central banks can explain their reaction function, but they can’t say what they’re going to do, because they don’t know what the economy will do.

Last but not least, average inflation targets are certainly stillborn. It never made sense to define future inflation in light of past mistakes. Will the US Federal Reserve really lower inflation below 2% to offset a prolonged surplus? What makes sense is to reaffirm your determination to achieve your future goal. But it is also possible that we have a degree of financial instability that forces us to think more deeply about it.

We must always remember how little we know about the economy. Central banks must be humble and prudent. They can’t ignore valuable information just because they don’t like what it shows. No, we cannot drive the economy through the money supply. But we can’t ignore it either. It contains warnings.