Those with an econ course under their belt typically have been exposed to Milton Friedman’s famous take on money and inflation which is: “Inflation is always and everywhere a monetary phenomenon.”
Actually, one doesn’t need a college course to be exposed to that idea. It appears almost daily in today’s newsprint. It is further stimulated by the anxiety created when the Fed expanded the monetary base by 56% since the onset of Covid (March 2020 to April 2021). That’s a big number especially when compared to the “accustomed “steady as she goes 3% per year growth of the monetary base.
Aside from a college course, the money-inflation connection is seemingly heuristic. That is, when the central bank prints more money, it implies that somehow the money gets distributed (also known as helicopter money) and we individually have more to spend and hence the price of goods is bid upward.
So, we should examine the linkage of central bank money to consumer spending power. It’s the important linkage and it has changed.
But first, here’s a heads up: The Federal Reserve does not stuff their newly printed dollars into your bank account affording you a larger bankroll to bid up the price of the goods you purchase.
In today’s unusual Covid times, it seems that way since the US Treasury (not the central bank) for the first time in our long history sent out green Treasury checks to individuals’ bank accounts with no further need on one’s part to do anything but to spending the money. It’s true the Fed had a hand in the transaction as they purchased the Treasury bonds that in effect financed the Treasury’s cash handouts but the handouts were not the central banks’ doing.
It is also true that during the Covid era, the PPP program enabled the Fed to lend on soft, soft terms to individuals, businesses and local governments. The authority for that ended on March 31, 2021 (a few months back) so the Fed is back to the same old rules of circulating the money as specified in the Federal Reserve Act. The list of those receiving the Fed printed money is short and gifting or lending it to private individuals and businesses, for them to spend, is NOT on that list.
The allowable items the Fed purchases with new money are: US Treasuries (which it buys in abundance), private debt but only if it carries a government guarantee (such as Fannies and Freddie’s), lending to member commercial banks (which was the original purpose of a central bank) and purchasing gold which takes us back to the Fed’s very beginning.
So how does that limited menu of Federal Reserve allowable items to purchase with printed money give rise to more spending by consumers in consumer goods markets and hence generate consumer and/or businesses inflationary pressures? The money gets into the hands of private spenders when it is loaned to them by commercial banks (as opposed to the central bank).
That is, the Federal Reserve, say in the first instance, buys a government bond from a commercial bank and pays for it with printed currency and the currency becomes the property of the commercial bank who in turn lends that purchasing power via demand deposits (checkbook money) to private borrowers for their spending uses with a consideration of interest. The banks’ borrowers can then spend the loan proceeds either by writing a check against their account or cashing in the demand deposit from their bank account and pay for goods with the cash proceeds.
So, this is the usual way for the Fed cash (Federal Reserve Notes) to work its way into the hands of private spenders which possibly creates sufficient spending to result in inflationary pressures in goods markets. So, when the commercial banks sell their Treasury holdings to the central bank, the commercial banks are paid in cash which in turn allows then to lends those funds to you or I in order to buy an auto, a house or perhaps lend to a builder that finances the building of a house which is presently happening in abundance.
This process has been called “the money supply multiplier” because the commercial banks are able to lend to their customers in amounts much greater than the central bank’s original purchase of bonds from the banks. What allows the commercial bank to ramp up the central bank money is that they in turn can and do create another form of paper money called demand deposits at some multiple of the cash they receive from the sale of their bonds to the Fed in the first place.
In the “olden” days prior to the “financial crisis” of about only thirteen years ago, the banks could lend approximately 8 times the amount of cash that the Fed put into circulation which magnifies new money issuance via demand deposits (checkbook money). The process is called the money supply “multiplier.”
The Fed’s portion of creating new money is called M1 and the commercial bank portion of money creation in the form of demand deposits is often called M2, in the language of economists.
M2 is accomplished when the bank lending creates demand deposits in the accounts of their clients, which could be you or me. It is in this way that central bank money gets into the hands of private spenders who in turn can transport that additional spending power into goods markets which can be expected to ultimately drive demand inflation.
However, in this current episode of central bank expansion, the “old time” multiplier of 8 is not being reached. The reason is the lending constraints that banks must live under were tightened about a decade ago following the financial crisis of that time. That is, the tightening of the regulation of bank lending reduced the explosiveness of the commercial bank M2 round of money creation and hence lending and spending has been materially defused. So, the effect of new Fed money (M1) leads to proportionately less bank money creation and lending (M2) which is in need of textbook revision.
So, there has been very aggressive M1 money expansion by the Fed since the Covid. Indeed, enough to finance additional private spending via the banks despite the substantially reduced M2 multiplier. But there is more going on to amplify inflation.
There has been a lot of discussion about workers not working and other supply side constraints recently. This raises the old-time question: “Is the inflation in consumer goods markets created by demand-pull or cost-push?
The cost-push mechanism derives from the fact that suppliers of many types of goods have lost some effective use of their labor force when the labor force needed to be at a distance from each other on the production floor. That in turn led to shortages of many inputs in the production processes.
And that will be true until labor overcomes its reluctance to show up for work given their Covid anxiety. Furthermore, many more do not show up for work when they are paid handsomely not to work by mis-guided and politically motivated governments.
So, the Fed prints and prints and the bank lending multiplier though reduced still provides sufficient support for aggregate demand to exceed labor constrained supply. So, the breakout of inflation is due to both the temporary supply limitations as much as the money induced spending.
Inflation still has a ways to run in this episode. If we can get past the labor force’s Covid paranoia and the Federal Reserve’s obsessive reflex to cover all economic setbacks with more money, than inflation will be contained.
So, the bottom line is that presently inflation has both demand-pull and cost-push aspects to it.
But it should be mentioned that there will be some built-in countervailing effects that likely will contain supply side inflation. Firms have had to learn to produce with fewer workers which is an increase in business productivity which will ultimately provide cost saving ahead and ultimately lower firm offering prices.
So, hang on to your hat. We’ve been through a lot with yet more to come. This episode is one for the economic history book, like “remember 2021” and you’re living through it. So, remember it well because some day your grand kids will be asking you about it.