Federal Reserve chairman Jerome Powell today acknowledged that he doesn’t understand inflation. See below.
This is somewhat alarming given the fact that the Fed’s is given operational independence to ensure price stability. If Powell doesn’t have a model for understanding why should the Fed been independent?
So we better help Powell.
Here is a simple model for US inflation.
By defition the following is given:
(1) n = y + p
n: nominal gross income growth
y: real income growth
In the medium to long run we know that y is determined by supply side factors such as productivity growth and labour supply growth.
We call that potential real income growth (y*).
We can use this to define demand inflation (pd):
(2) pd = n – y*
The graph below shows pd and actual US inflation (CPI).
We see that over the past two decades actual inflation and pd as followed each other fairly closely with pd generally leading actual inflation.
This was for example the case during the Great Recession where we see demand inflation slowed significantly starting in 2006, while actual inflation intially stayed elevated (due to a negative supply).
If we look at the situation over the past two years we see that initially we saw a sharp drop in pd, but also a fast and sharp recovery followed by a massive spike in demand inflation – peaking above 16% in Q2 2021. Demand inflation has since slowed but continue to grow fairly strongly. Annualized demand inflation in Q1 2022 was around 10%.
If we compare this with actual inflation we see that actual inflation slowed in 2020, but only moderately compared to demand inflation. This negative demand shock was instead reflected in a sharp rise in unemployment.
However, as demand recovered fast in 2020 so did real income growth and as we entered 2021 the level of real gross domestic income rose above potential real gross domestic income. In textbook lingo we hit the vertical long-run supply curve and consequently we should expect any growth in nominal income above this level to cause an increase in inflation.
And this was exactly the time when actual inflation started to accelerate – around April-May 2021 and ever since then US inflation has continued to rise.
There should be nothing surprising in this – if the central bank tries to push real income (Y) above the potential real income (Y*) then we should expect increased inflation.
And we should expect actual inflation to continue to increase as long as demand inflaion is above actual inflation.
We have not yet closed the gap between demand inflation and actual inflation, but we are getting closer and we should expect inflation to start to level off in the coming months.
What the Fed can do
Our simple model for US inflation hence seems to pretty well expain the development in actual inflation and we can conclude that the sharp increase in inflation in the US primarily has been caused by a sharp increase in nominal income growth.
The question is what drive nominal income growth. Again lets go back to the textbook.
The equation of exchange (in growth rates) is defined in the following fashion:
(3) m + v = p + y (= n)
Where m is money supply growth (for example M2) and v is money-velocity growth.
We can therefore also alternatively define demand inflation in the following way:
(4) pd = m + v* – y*
Where v* is the trend-growth rate of v* (for example 10-year moving average).
The graph below shows this alternative defintion of pd.
We are using monthly data where we have used real and nominal personal consumption expenditure (PCE) as proxies for n and y*.
This graph should make Powell optimistic – even though he apperantly do not understand the causes of inflation he has nonetheless managed to slow demand inflation in the last couple of months and in May pd growth had declined to around 6% – hence below the actual rate of inflation.
Consequently, assuming that Powell doesn’t speed up money supply growth going forward or a negative supply shock hits the US economy then we should expect inflation relatively soon to start to level off and gradually start to decline towards 6%.
Back in April last year I warned US inflation could hit double-digit numbers and we might still get there in the next 1-3 months, but it is encouraging that the Fed now has stepped on the brakes and money supply growth has slowed considerably.
As the graph above shows M2 has basically been flat in the past six-seven months and it therefore should not be a surprise that we are also beginning gross domestic income growth slowing, which is causing a drop in demand inflation and we there should expect actual inflation also to slow. To some extent the slowdown likely is also due to a decline not only in the money supply growth but also due to a decline in money demand due to higher interest rates.
The slowdown in M2 growth in 2022 has actually been faster than I assumed in my inflation call from April 2020 and furthermore, even though money-velocity is trending upwards the uptrend is rather muted and more muted than I had expected.
So even though Powell claims not to understand the reasons for inflation it seems like at least in terms of slowing money supply growth and therefore slowing gross nominal income growth he is doing the right thing – at least at the moment.
It is, however, still rather alarming that he apperantly doesn’t know why and how he is doing the right thing.
Hence, the Fed continues to need a proper framework for ensuring nominal stability in the US economy. I hope this blog post can inspire the Fed to re-learn that inflation is a monetary phenomenon and that it is the task of the Fed to control money supply growth in such away that nominal income growth is stable so inflation ultimately is low, stable and predictable.
It really isn’t that hard.
PS 4% nominal gross domestic income growth would more or less ensure 2% over the medium-term. I have earlier suggested that the Fed over the coming 5-10 years gradually bringes the NGDP level path back to a 4% path starting in Q1 2017.