- Peter Stella
Some Incredible Monetarist Arithmetic
During the last 13 years, the U.S. monetary aggregate known as M1 has grown at an average annual rate of 22.3 %, while inflation has averaged just 1.7%. If the central prediction of the quantity theory of money (QTM)—that long-run average growth rates of money tend to equal rates of inflation—is correct, then dramatic changes will need to be forthcoming during the next couple of decades in either the rate of growth of money, the rate of inflation, or both.
Global financial markets appear to believe that there will not be a dramatic uptick in inflation. Despite over a decade of double-digit annual rates of money growth, market expectations reflected in TIPS break-even rates suggest that U.S. annual inflation will average 2.4% during the next 20 years, which in turn implies that today’s capital market investors expect the rate of annual inflation over the long run to average only 2.2% which can hardly be described as a dramatic change from the past.
Market expectations of low inflation and the fundamental long-run prediction of the equality of inflation and money growth can be reconciled, of course, with a fundamental and dramatic reversal in money growth going forward. Although not impossible, basic arithmetic suggests it would be even more globally unprecedented than the high rates of money growth that preceded it. Even if US money growth were zero for the next 17 years, inflation would need to average over 15% percent per year over those next 17 years to bring its 30-year average into line with the average rate of M1 growth through 2038. In that case both M1 growth and inflation would average 9.1 percent over the 30-year period 2008 – 2038.
Viewed from another perspective, the QTM implies that the annual growth rate of US M1 would need to average -11% over the next 17 years to bring it into equality with market inflation expectations of inflation. Again, not impossible, but since 1960 the twelve-month growth rate of M1 has fallen below -5 percent only once (in April 1997, - 5.4). And although folk memory might think Paul Volcker brought down the rate of growth of money in order to break the back of U.S. inflation in the 1980s, the reality is that M1 growth averaged 8.8% per year while he was at the helm of the Fed compared to an average annual growth rate during the eight years prior to his term of only 5.8%.
Although there were numerous respected voices who called for an end to “excessive” money growth early on after the Fed responded to the GFC with massive liquidity assistance—see, e.g., Wall Street Journal (2010), An Open Letter to Ben Bernanke, November 15, with the passage of the years and virtually no uptick in inflation in the US, Eurozone, UK, Japan, and other countries witnessing high rates of money growth, these voices have become few and far between. And is there anyone credibly prophesizing inflationary doom along the lines of the simple monetary arithmetic outlined above? I think not. Are there those arguing for shrinking central bank balance sheets to straighten out the muddled money markets—yes, myself included. Are there those arguing for interest rate rises sooner rather than later to avoid inflation creeping up a few percentage points—indeed there are, including within central banks. But is there any plausible argument that relies on the QTM to portend that even if money growth is zero over the next 17 years US inflation will average 15% per annum during that period?
At some point—perhaps 13 years is long enough—the logical position is not to continue to argue that we have not waited long enough to witness the unfolding of the QTM in the “long-run” but to ask why the theory appears to be on the verge of a colossal failure in dozens of countries.