Where should the US inflation rate go?

In the last five months currency in circulation and M1 in the US have grown at annual rates of 11.7% and 25.7%, yet the price level has decreased at an annual rate of 6.9%* . Some economists expect inflation, others, deflation. Part of the lack of consensus is due to the phrase “inflation is always and everywhere a monetary phenomenon”. Fortunately, it was Milton Friedman himself who played down the importance of money recently**.

Inflation is regime dependent. In a regime where the fiscal deficit is financed by printing money inflation is caused by monetary growth, an example is today’s Zimbabwe. In a regime where monetary policy has credibility, and no fiscal deficit is paid by printing money, inflation (or disinflation) is not caused by monetary growth but by aggregate demand and marginal cost, an example is the current situation in the US. The former story has been famously defended by Phillip Cagan and Thomas Sargent among others. The latter belongs to the New Neoclassical Synthesis (NNS), an example is the Phillips curve in the textbook by Michael Woodford, Interest and Prices (2003, page 159).

As inflation is regime dependent there is no “always and everywhere” kind of law to explain it. Can there be more than one explanation to the same phenomenon? Sure, fever may be caused by virus, bacteria, fungus, parasite and others.

It is difficult to say anything that contradicts Milton Friedman because doing so sounds somewhat arrogant. So we economists often try to rationalize the facts with the famous phrase using apologies like “inflation is always and everywhere a monetary phenomenon” in the long term, or “inflation is always and everywhere a monetary phenomenon” across different policy regimes. This is like saying that the cause of death is a cardiac arrest in the long term or across different fatal diseases because in the long term we will all be dead and eventually the heart will stop pumping.

The problem with Friedman’s roundabout etiologic statement is that it does not help us maintain control over inflation. This is the “success argument” of the philosophy of science. Grossly stated, the argument says that if we are successful with a theory it would be hard to say it is not “true”. For instance, we are confident that some infectious diseases are caused by bacteria because this diagnostic has helped man exert control over them through the prescription of antibiotics. In like fashion, raising the rate of money growth may not help stop the current US disinflation and risk of deflation but combating the drop in aggregate demand may.

*A caveat is in order. The growth of currency in circulation and M1 is rather ordinary compared to the growth of the monetary base. Base money has exploded but the Fed has kept much of the explosion out of circulation. The $817.1 billion explosion of the monetary base since June is not really money in circulation as (remunerated) bank reserves in the Fed increased by about the same amount. The balance sheet of the Fed (assets and liabilities) has risen by some 500 billion more but this was kept out of circulation by a comparable increase in the Treasury’s deposits in the Fed. This is a good example why the definition of money by the IMF does not include the government’s deposits in the central bank.

**Simon London, “Lunch with the FT: Milton Friedman”, Financial Times, June 6 2003.