Reckless Monetary Expansion

The excessive borrowing by the federal government in response to the Covid-19 economic shutdown is beginning to show up in economic statistics. As I have explained already, there was no need for the stimulus checks, and the combination of those checks, the unemployment bonus and excessive monetary expansion to fund the Gargantuan deficit may create a perfect storm of inflation.

The monetary component in this inflation threat is particularly serious. Other forms of inflation can usually be dampened with fiscal policy and other real-sector measures that allow the economy to return to price stability. Monetary inflation, however, creates a pricing pattern in the economy that is immune to such measures. Non-monetary inflation forms, often referred to as demand-pull and cost-push, depend on pricing of goods and services in various parts of the economy. By contrast, monetary inflation injects purchasing power into the economy that has no ground in any real-sector activity whatsoever.

Before we look at some frightening numbers on our monetary expansion, a note is needed on why high inflation is so dangerous. We have not had an experience with it in America, which very likely has insulated our policy makers against the dangers that come with it.

Technically, higher inflation means that prices are marked up by bigger percentages than usual. The higher the inflation rate gets, the larger the price increases in any given year. Furthermore, when inflation rises past a “breaking point” – somewhere in the bracket of 10-50 percent inflation – price setters start making price changes more frequently than otherwise. This results in an acceleration of the inflation rate by virtue of the “compound interest” effect.

The pricing frequency shortens because price setters do not want to be wrong in their price expectations. For every pricing period there is an expectation of how much prices will rise in general; if the price setter learns that he has under-estimated inflation, he will mark up his prices more, and more frequently, in the future. The higher inflation climbs, the steeper the price for being wrong about it: high inflation feeds expectations of higher inflation, which in turn feeds a behavior that makes those expectations come true.

Plain and simple, high inflation becomes a self-fulfilling prophecy. Monetary inflation is the most dangerous type of inflation, driving the rate of price increases up faster than any other form. Therefore, it is also the inflation type that most rapidly gains a momentum of its own. This is why our history is full of hyper-inflation episodes driven by reckless monetary expansion.

We are far away from hyper-inflation, and chances are we will never get there. However, every path to runaway prices hikes begins with a first step – and we have now taken that step. Figure 1 has a frightful story to tell:

Figure 1: M1 Annual Monetary Expansion

Source of raw data: Federal Reserve

The liquidity that has now been pumped out in the U.S. economy has to go somewhere. Transmission mechanisms between the monetary and the real sectors have already gone to work, and will continue to work their way spreading this liquidity. Since this money is printed out of thin air, it does not constitute payment for any real-sector transactions, but it just dropped into the real sector in the form of a massive line of credit.

Bluntly, spending materializes out of thin air. The real sector of the economy is suddenly supposed to respond to spending that no intra-real-sector transmission mechanisms have accounted for. The result will be a spike in prices.

I am not going to speculate in how high our inflation rate will be as a result of this monetary expansion. What we can say with certainty, however, is that our path to high inflation will be determined in the near future. If this enormous increase in money supply is at least partly reversed in the second half of this year, we may have dodged the inflation bullet. If not, we are in trouble.


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