There’s More to Inflation Than the Money Supply

The printer may be going "brrrrr" but increasing the money supply doesn't necessarily lead to inflation, writes EY's blockchain leader.

AccessTimeIconApr 5, 2021 at 2:29 p.m. UTC
Updated Sep 14, 2021 at 12:35 p.m. UTC

In a prior column, I argued it’s a myth that America is headed towards catastrophic hyperinflation. I got a lot of angry messages on Twitter about this, and nearly all of them (that weren’t obscene) cited quantitative easing (QE), where central banks buy financial assets to increase the money supply.

The money supply has indeed grown significantly and the U.S. is about to embark on a historic experiment in combining very loose monetary policy with a big fiscal stimulus. This may seem like pouring gasoline on a fire, but there are four good reasons to think it might work out very well.

The velocity factor

The money supply may be much bigger but the velocity of money dropped dramatically at the start of the pandemic and is recovering slowly. The velocity of money is just how fast money moves between parties. Simply put, no matter how much money exists in an economy, if nobody spends it, the economy is actually very small.

Paul Brody is EY's Global Blockchain leader.

At the start of the pandemic, people chose to save rather than spend, and the rate at which money changes hands declined dramatically. In fact, it was the steepest drop ever recorded, even a bit steeper than during the 2008-9 financial crisis, according to Federal Reserve data. QE raised the amount of money in the economy in an attempt to offset this decline, but even so the U.S. had its worst quarter of GDP decline ever in Q2 2020 and output remains below the pre-pandemic level now.

The output gap

Though the economy has staged a big recovery since the beginning of the pandemic, not only are we still below our pre-recession output, but the potential output we can achieve has been growing. The output gap is the difference between what is being produced by the economy and what could be produced. The size of the output gap is a good measure of how much the economy can grow without triggering inflation because companies want to raise output before they start raising prices.

Even though we have been in a deep recession, in fact the economy’s output capacity has continued to rise. Indeed, there is a growing group of economists who believe the pandemic has kicked the digital transformation of the U.S. economy into overdrive. Instead of an orderly and conservative implementation of new technology, the pandemic caused a stampede as companies switched to home working.

One good estimate is that the pandemic packed a decade’s worth of transformation and acceleration into a single year. If other parts of the economy have been as suddenly and as swiftly transformed as the retail sector, productivity may well continue to grow rapidly

Current estimates are that we have an output gap of between $400 billion and $700 billion in the U.S. and the gap is even larger in other parts of the world that have not pursued such large stimulus packages. Even if the U.S. closes its output gap, companies may turn to more productivity technology and imports before they start raising prices.

Online shopping

There has been remarkably little inflation in the last 20 years, despite several time periods where the U.S. economy seemed to be running hot with high demand and low unemployment. Increasingly, economists think that online shopping may have made it much harder for companies to raise prices.

No matter how much money exists in an economy, if nobody spends it, the economy is actually very small.

Consumers don’t like rising prices, but in the past they may not always have had a lot of choices. Today, online shopping means not only can people compare prices but they can also easily find substitutes at lower prices. And while not everyone carefully does comparison shopping, enough are doing so that companies will notice demand changes quickly and social media makes it easy for people to spread the word about cheaper alternatives.  

The result: Companies have struggled to raise prices and make them stick.

A little inflation?

For all these reasons, even with strong demand and loose monetary policy, there is still a risk that we will see a small but noticeable burst of inflation. The economy is a super-tanker not a speedboat, and changes in big policies like interest rates can take a while to filter into the economy. Even if the Federal Reserve raises rates today, for example, if you have locked in a low-interest rate mortgage for several years you may not see immediate effects on your cost of living or your buying decisions.

If inflation does start up and look to be sticking, central banks in the biggest economies, such as the U.S. and Europe, are charged with the responsibility of maintaining long-term economic stability. While no institution can be entirely insulated from politics, both the U.S. Federal Reserve and the European Central Bank have strong institutional structures that prevent short-term politics from upsetting long-term economic goals. In the U.S., the Fed’s board of governors are appointed to staggered 14-year terms.

People should worry about significant bursts of inflation in countries where the rule of law and the independence of central banks is not guaranteed. When that happens, the option to print money for political gain now and pain later can be very tempting.


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