The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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July 28, 2010

The money-inflation connection: It's baaaack!

Our St. Louis Fed colleague David Andolfatto declares it is time to bury the old saw that says when it comes to inflation, follow the money:

"One of the ideas that stuck in my head as an undergrad was the proposition that 'inflation is always an[d] everywhere a monetary phenomenon.' The idea is usually formalized by way of the Quantity Theory of Money (QTM)—or more precisely—the Quantity of Money Theory of the Price-Level. (QTM is not a theory of money, it is a theory of the price-level).

"In its simplest version, the QTM asserts that the equilibrium price-level is roughly proportional to the outstanding supply of money (however defined). As inflation is the rate of change in the price-level, the phenomenon of inflation is attributed primarily to excessive growth in the money supply (typically viewed as being controlled by the monetary or fiscal authority)."

Andolfatto goes on to note that the monetary base—the sum of currency in circulation and the banks' reserve balances held at the Federal Reserve (at that page, search "reserves")—more than doubled since fall 2008, while the rate of inflation fell.

That's certainly true, though most versions of the quantity theory applied to monetary policy discussions lean on broader measures of money—for no better reason than those measures help the theory fit the facts. Specifically, since the 1980s the phrase "inflation is everywhere and always a monetary phenomenon" has in effect meant "inflation is everywhere and always a monetary phenomenon when we measure money by M2."

And here's an interesting thing. If you look at the relationship between M2 growth and core inflation over the past decade and a half, it appears that the money-inflation nexus has been gaining in strength:


Another way to see this relationship is to look at the correlation between M2 growth and core inflation over rolling 10-year windows:


Could it be that the death of the quantity theory has been greatly exaggerated?

There are plenty of reasons to be cautious. For one thing, it is oft-noted that any connection between money and inflation could be purely coincidental. In fact, if you stare hard at the picture it does appear that changes in inflation often precede changes in money growth. One interpretation is that the same factors that push trend inflation around also result in responses by policymakers or private market participants that ultimately cause the money supply to move in a sympathetic direction.

But even if causation does run from money to prices, the case is not quite solved. The monetary base measure that the Andolfatto post emphasizes has a lot to recommend itself, not least being that it is the measure of money that central banks actually control. The stark disconnect between the growth in currency and bank reserves (the quantity of which is determined by the Fed) and M2 growth (the quantity of which is determined by the decisions of banks to expand their balance sheets) raises legitimate questions about how policymakers would exploit an M2-inflation connection in an environment when the monetary base–M2 connection—the so-called "money multiplier"—has changed so dramatically.

There could be lots of answers to that question. The relatively new Federal Reserve policy of paying interest on bank reserves is one possibility. Andolfatto's suggestion that all changes in money are not created equal might contain the germ of another explanation. For our part, we think the question is quite a bit more than academic.

By Dave Altig, senior vice president and research director at the Atlanta Fed, and Brent Meyer, economic analyst at the Cleveland Fed

July 28, 2010 in Federal Reserve and Monetary Policy , Inflation , Monetary Policy | Permalink


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I thought that the old "monetary aggregates" version of the quantity theory -- where something like M2 is taken as an exogenous determinant of inflation -- was pretty much discredited by the policy experiment in the early 1980's. The Fed tried to control M1 (which should be easier to control than M2) and found that (1) it couldn't and (2) the correlation became much weaker. It's not a very convincing response just to say they were trying to control the wrong aggregate.

Posted by: Andy Harless | July 28, 2010 at 05:36 PM


How does the 12 month rolling change in consumer credit and mortgages effect the relationship between M2 and core CPI? Do they weaken or strengthen the correlation historically?

Posted by: Bryan Byrne | July 28, 2010 at 06:18 PM

"There could be lots of answers to that question."

Looking forward to your follow-up on this, though didn't you kind of get started immediately prior:

...."growth in currency and bank reserves (the quantity of which is determined by the Fed) and M2 growth (the quantity of which is determined by the decisions of banks to expand their balance sheets)" ?

Throw in a bit of variable V and nowhere near full employment Y, and I can't wait to read it!

Posted by: apj | July 29, 2010 at 09:19 AM

There is a problem with the proposed interpretation of the money-inflation link illustrated in the upper Figure. M2 lags behind CPI by quarters. Effectively, CPI goes its way and M2 is adjusted to inflation. This is a pure artificial consequence of monetary policy.
The link implies that M2 drives CPI, what contradicts observations.

So, if the authorities decide not to follow inflation, the link will disappear. But inflation goes its own way, very likely M2-independent one.

Posted by: kio | July 30, 2010 at 05:23 AM

I actually had a former Fed governor tell me that the reason former monetarist Greenspan was ok with interest rate targeting was because they basically lost track of velocity due to rapid changes in banking, like ATMs and so forth. Now perhaps things are stable...this should give impetus to returning to a rule based policy rather than the failed practice of interest rate timing, such as advocated by Krugman (http://blog.mises.org/10153/krugman-did-cause-the-housing-bubble), which ex post has proven to have been disastrous.

Posted by: pete | July 30, 2010 at 10:27 AM

Nothing has changed. Monetarism has never been tried.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired rates-of-change (roc’s) in monetary flows (MVt) relative to roc’s in real GDP.

Where, money is the measure of liquidity, the yardstick by which the liquidity of all other assets is measured. And the transactions velocity is money actually exchanging hands (the G.6 metric).

Nominal GDP is the product of monetary flows (M*Vt) (or aggregate monetary demand), i.e., our means-of-payment money (M), times its transactions rate of turnover (Vt).

To: anderson@stls.frb.org
Subject: As the economy will shortly change, I wanted to show this to you again - forecast:
Date: Wed, 24 Mar 2010 17:22:50 -0500

Dr. Anderson:

It's my discovery. Contrary to economic theory and Nobel Laureate Milton Friedman, monetary lags are not "long & variable". The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically (for the last 97 years), always, fixed in length. However the lag for nominal gdp varies widely.

Assuming no quick countervailing stimulus:

jan..... 0.54.... 0.25 top
feb..... 0.50.... 0.10
mar.... 0.54.... 0.08
apr..... 0.46.... 0.09 top
may.... 0.41.... 0.01 stocks fall

Should see shortly. Stock market makes a double top in Jan & Apr. Then real-output falls from (9) to (1) from Apr to May. Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down.

Posted by: flow5 | August 02, 2010 at 10:49 PM

That's the beauty of monetary flows (lags), i.e., our means-of-payment money X its transactions rate of turnover. The economy turns when the numbers turn, not before or after (i.e., it's too soon & stocks should now be rising per MVt).

The proxies for real-output or inflation indices historically (for the last 97 years), oscillated at matching lengths. Money flows signaled the April month-end decline.

The upcoming drop in the proxy for inflation(-48): Sept month-end until Jan month-end.

The upcoming drop in the proxy for real-output(-10): Aug month-end until Feb month-end.

The FED capitulated in May. That is, the FED offset half of the decline in (MVt) after it started to decline. The FED could easily offset all of the drop in real-output this time around.

However there is no way that it can stop the catastrophic drop in inflation -- even with QE2.

Posted by: flow5 | August 02, 2010 at 10:54 PM

your graph seems to indicate the causality is the opposite, that cpi is leading m2 rather than vice versa as would be predicted by the theory. this is not a new observation, economists have been writing since the 1950s that the evidence tends to support the economy driving money growth.

Posted by: ts | August 05, 2010 at 01:04 PM

M3 is all that matters, period. Without lending...

Posted by: warren | August 07, 2010 at 11:39 AM

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