How the inflation story changes when the "one-legged monetarist"...

receives a "prosthetic second leg"

The two charts below, both from Spring 2020, April and June, respectively, are illustrative of the “one-legged monetarist” view that the only thing that matters for inflation is the growth rate of the money supply.

And the prediction was that after a suitable interval of time inflation would increase substantially.

Let us travel back 80 years and take a look at the first several months of the Great Depression. During that time frame, real output (RGDP) growth was -13%, and there was no inflation, but deflation. If you look at the money growth chart, showing that the quantity of money was quite stable during that period, you would have a hard time forecasting, or explaining, the deflation that took hold!

The “one-legged” monetarist looks at the Quantity Theory equation in growth form: M+V=P+y, where M is the growth in money supply, V the growth in velocity, P inflation and y the growth of real output, and assumes V is stable (a leg that doesn´t move). Further, in the medium to long run, real output growth is determined by real factors, so that, rewriting the equation as M-y=P they conclude that higher M growth will result in higher inflation P (that´s the meme of “too much money chasing too few goods”)

Now, if you allow the V leg to move, the inference changes. The chart below allows you to understand why, despite stable money growth, inflation became deflation. Note that while M remained stable, V fell substantially, so that M+V turned negative. Therefore P+y, or aggregate nominal spending, NGDP, fell significantly, with both P and y becoming negative.

Switching to the present, this article, written in the Spring of 2020, has the title “Will the Current Money Growth Acceleration Increase Inflation?” To pose that question, the author must have been looking at something similar to the money growth chart at the top of this post. As I´ll show, the better question at the time would have been “Will the Current Money Growth Acceleration Help Avoid a Second Great Depression?”

As the panel below indicates, it did! When the pandemic hit, velocity tanked. Money supply growth reacted with a delay, thus avoiding the worse for nominal and real spending growth and an undesired bout of deflation. Just imagine what would have happened if money supply growth had remained stable as it did during the first leg of the Great Depression.

Fast forward, the last few months show that things have reversed. The waning of the pandemic has resulted in a significant rise in velocity. Money supply growth has fallen significantly, although not enough to offset the rise in velocity. This has allowed NGDP growth to “blossom”. When NGDP, velocity and RGDP data for May become available in the next few days, my expectation is that NGDP growth will have cooled off somewhat.

Although RGDP growth was robust in April on an yearly basis, it was constrained by supply bottlenecks (including labor supply). These tend to be temporary and may be losing force already, given the less dramatic rise in inflation in May.

Going forward, the interplay of velocity and money supply growth will determine the evolution of NGDP growth, RGDP growth and inflation. Remaining supply bottlenecks will determine the short term breakdown of NGDP growth between inflation and real growth.

In April, the level of NGDP had returned to the path it was on before the pandemic. Given what the Fed has said, it wants to take the economy to a higher level path. I have no doubt it can achieve that goal. The behavior of the money supply will determine, given what happens to velocity, how quickly that “target” will be reached.

Trying to get there “too quickly” will have an impact on inflation, but path corrections can be implemented without much delay.

My point is that all the forecasts of “coming inflation” due to the money supply growth observed in the first half of 2020, were “empty”. The increase observed in money supply growth was what was needed to avoid a crash in the economy. As always, inflation will be determined by the interplay of money supply and velocity, given the Fed´s objective (even if implicit) for the level path it wants the economy cruise along.

Note: The monthly GDP data is available here, while the M4 Divisia monetary aggregate is avalable here.