Friday, June 22, 2012

Where Has All the Inflation Gone?

Price inflation that is. Inspired by Robert Murphy's post here, I decided to discuss why CPI hasn't picked up that much even though money supply is through the roof.

First, how does inflation in consumer prices occur? Well, it is because the purchasing power of money has decreased, which is a result of an increase in the supply of money. So far, this is not controversial. But there is an element missing, and that is the demand for money. Money may not have a unique price but it does have supply and demand functions. The purchasing power of money will not change if the supply and demand for money change in parallel. In other words, if the supply goes up to meet a higher demand to hold money, then we should not observe a change, or much change, in the purchasing power of money.

The problem is that there is no objective measure of the demand for money. It must be estimated. One proxy for demand is excess banking reserves. Normally this wouldn't tell us anything, because it normally is zero. But recently it has gone up quite high (see graph below).

The blue line is Money of Zero Maturity (MZM). The green line is CPI (on the right axis), and the red line is excess reserves. Note the CPI going up every year as money supply increases every year. As excess reserves pick up, CPI drops down and rises more slowly. Excess reserves have increased to nearly $2 trillion since mid-2009, and MZM has increased by roughly $1 trillion. So under these circumstances, I would not expect much price inflation.

Note, however, that these excess reserves are induced money demand, because the Fed is paying 0.75% interest on excess reserves. Normally the interest on excess reserves is zero. So if a loan was going to return 5% interest before, now it has to return 5.75% interest. I don't know how much of the excess reserves is due to only this factor, however. The demand for loans might be low too (meaning demand for money is high).

To highlight another point, I do want to mention that even though CPI is low relative to zero, that doesn't mean it's low relative to what it would be on the free market. Suppose that, without changing money supply, prices would have decreased by 2% (change in CPI = -2%). Then, with an observed CPI of +2%, the actual price inflation is 4% (2% - -2%). But we have no idea what prices would actually do on the free market, except that they have a tendency to decrease (look at computers and televisions, for example).

Finally, an increase in money supply, even to match an increase in money demand, has pernicious effects on the economy that may not show up as price inflation. That is because the new money travels through the economy in a certain way that likely doesn't match the increase in money demand. To increase money supply, the Federal Reserve Bank of NY credits the accounts of its primary Treasury-security dealers with money in exchange for the securities which are sold to FRBNY. Then the money is lent out or traded by the primary dealers (which are primarily investment banks, but also commercial banks) with its trading partners or commercial clients. Then the money slowly moves through the economy as businesses make investments, or more trading occurs, or what have you. It's impossible to know what the reordering will be, and how large it will be. If the increase in money supply is small, the reordering is likely to be negligible. But if it is sustained for a long time, the reordering will be vast. But we may not recognize that the economy is structured counter to the wishes of consumers until the bust actually arrives, and then it's too late. But if you want to read more about that, check out Austrian Business Cycle Theory at


  1. The western world is in a balance sheet recession. Until there is sufficient deleveraging, inflation will be a non-issue.

    1. Thank you for commenting on our blog.

      I agree that the decline in asset values is very important for this recession. That would suggest a lack of demand for investment funds, and that's why the reserves have built up so much.