Economic Newsletter #1 2021
How do we estimate the risk for monetary inflation in the U.S. economy? This the first issue of the Liberty Bullhorn Economic Newsletter presents a unique model for calculating the monetary inflation gap. The numbers are crisp clear, and lead to a troubling inflation forecast.
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About the author: Sven R Larson, Ph.D., is a political economist with 40 years of experience from politics and 15 years in public policy. He has worked as an economic and policy analyst for private companies, think tanks, elected officials and political campaigns. His experience in macroeconomic and policy analysis spans three decades and two continents. His work is completely independent and unbiased.
Monetary Inflation: An Analysis
Copyright Sven R Larson. Do not quote or share without permission.
With the dangers of high inflation rising, it is essential for all economic and financial decision-makers to get as much insights as possible into how fast inflation is approaching, how bad it will be and what it will do to our economy. Inflation is a venom that, in high enough dosages, can be lethal to the economy. However, it does not take much inflation to do serious damage: even long before the economy is crippled by out-of-control price increases, inflation rates in the 10-20 percent range are harmful, especially to smaller businesses and households without high net worth.
But is inflation at such rates even theoretically possible in the United States? A year ago the answer would have been a resounding “absolutely not!”. Today, though, we have a monetized inflation gap in our economy, which serves as a foundation for high inflation rates. We have not had a gap like this, ever before.
In this issue of the Liberty Bullhorn Economic Newsletter we explain this gap and demonstrate how it is estimated. The numbers presented below give a unique perspective on how the Federal Reserve, by flooding the economy with new money supply, is creating a serious inflation risk for 2021.
We are unique in making this inflation forecast. Therefore, let us start with a look at why those are wrong, how suggest that there is no inflation in our economy, and no inflation coming our way.
The topic of inflation is almost universally absent in mainstream economic and financial commentaries. In alternative outlets the story is actually that we have deflation in the U.S. economy. One example is Creative Destruction Media, which on December 17 suggested that “deflation is a thing”. Pointing to stagnant import and producer price indices, they misunderstand the transmission mechanisms that cause inflation.
This analysis is based on a misunderstanding of the causes of inflation, specifically the monetary causes. When monetary inflation first surfaces, it does not enter the economy through production costs. It makes its entry between supply (production and imports) and demand (consumption and investments). When money supply expands to a point where it builds up inflation pressure, it does so by decoupling demand from supply.
To understand monetary inflation, it is essential to first understand this decoupling process. When money supply is proportionate to economic activity – in other words there is no excess expansion of money supply – it follows the ebbs and floods of the so-called transactions demand for money. This is the demand for money to pay for regular, real-sector economic activity.
So long as money supply largely follows transactions demand for money, there is no meaningful monetary inflation gap in the economy. Therefore, there is no monetary pressure on prices. That does not mean there is no inflation – there is – but it is caused by interaction of demand and supply in individual markets. Excess demand results in demand-pull inflation, which is never significant enough to cause serious harm to the economy.
The reason is to be found in how spending is funded in a normal economy (without excess money printing). Total demand, i.e., consumer spending, business investments, government consumption and net exports, is paid for out of income earned through work and investments. The totality of this income is therefore well balanced against total supply – domestic production plus imports – which in turn means that demand-driven fluctuations in consumer prices will closely follow producer and import prices. The causality is from demand to supply, i.e., from spending to production.
The CD Media observation of production and import prices leads to the conclusion that there is no demand-driven inflation. It also leads to the conclusion that there is no cost-push inflation. This type of inflation makes its first appearance as increased costs of producing goods and services. A classic example is a rise in payroll taxes. Spikes in oil prices have also been referred to as examples of cost-push inflation, though one should be careful with conventionally classifying oil-price spikes as supply-side, cost-push inflation.
When costs of production go up, producers transfer the cost hike to their buyers as far as they possibly can. Producer prices rise first, followed by consumer prices.
It is sometimes difficult to statistically distinguish between demand-pull and cost-push inflation, as they tend to work in tandem through a business cycle. However, they are analytically different from monetary inflation:
- Demand-pull and cost-push inflation evolve from the dynamics between demand and supply;
- Monetary inflation enters the economy as a wedge between supply and demand.
We recently noted that there is an inflation tendency in consumer prices. Since the same tendency is not visible in prices on production and imports, this is one sign that we already have monetary inflation in the U.S. economy.
It is, however, not a sufficient sign for us to give any meaningful estimate of whether we have a solid monetary inflation gap (between supply and demand) and, if so, how high inflation may rise. The analysis below explains how we can establish the existence of a monetary inflation gap.
First, though, a note on the transmission mechanism from money to prices.
Monetary transmission mechanisms
The origin of monetary inflation is not the real sector of the economy – supply or demand – but the financial sector. This concept is not to be misunderstood as “banks”, but is instead a concept related to the nature of an economic transaction:
- In the real sector, every monetary transaction – every payment of cash – has a counterpart in a product (good or service) being shipped in the opposite direction. This balance is what keeps tabs on cost-push and demand-pull inflation.
- In the financial sector, there is nothing going in the opposite direction of a monetary transaction.
Emphasis here has to be on government, which is the unchallenged transmitter of money to inflation. The main conduit is the system of financial transactions that government carries out on a regular basis. Every Social Security payment is a financial transaction; the covid-19 stimulus checks paid out last spring were financial transactions. The list of examples is almost endless when government is involved.
The cash going out the door under government programs injects purchasing power – income – between supply and demand. This leads to spending in the economy that is not counter-balanced by an increase in productive value. If the gap between the two is monetized, i.e., funded by newly printed cash straight from the Federal Reserve, then it creates an upward pressure on consumer prices. Since this pressure does not originate in import or producer prices, it is not visible there.
Once we have established what the transmission mechanisms look like from money to prices, we can take the next step and identify where our current money supply is getting in to the real sector of the economy. Doing to yields a major clue as to the inflation pressure in our economy.
We will do this in just a moment; first, another contrasting view. This one is from a commentator who, while looking at money supply, draws the erroneous conclusion that it does not constitute an inflation threat. Over at Zerohedge, in a reprint from The Great Recession Blog, David Haggith hypothesizes that the recent expansion of M1 money supply, specifically that which happened in November, is driven by wealthy, tax-planning Americans moving a lot of cash around. This is manifested, he suggests, in wealthy Americans moving cash from savings accounts or certificates of deposit to checking accounts.
This approach to the monetary expansion is classic in its mistaking technical details for intentional acts. The cash that constitutes the surge in M1 is intended to bankroll deficit-funded government spending. In fact, as we will see in a moment, it is consistent with a monetary policy aimed at monetizing budget deficits. Again, the transmission mechanism is what matters: to fund a deficit, new money supply has to move through the banking system, into the eventual checking accounts from which the money will be spent.
It is this process that Haggith is reporting and misidentifying as tax planning.
Now over to the money-driven gap in the economy that creates upward pressure on prices.
The monetized inflation gap
Money printing causes inflation when two conditions are met. The first is that there is an open transmission mechanism from money to prices. This transmission mechanism must work the money into the real sector of the economy.
Theoretically, the transmission from money to prices can happen any which way the new money supply is transferred into the pockets of consumers and entrepreneurs. In practice, the only transmission mechanism with enough force to cause inflation, is government spending. Therefore, in order for money to cause inflation, government must use new money supply to fund its outlays. In other words, it must run a budget deficit that it finances with newly printed cash.
The second condition for monetary inflation is that the money supply is used for government spending that does not pay for any real-sector activity. For example, it cannot be used to pay teacher salaries. In other words, to cause inflation, newly printed cash must work its way into the economy where there is no real-sector transaction taking place.
By definition, these are financial transactions, which take two forms:
a) Liquidity supply to businesses in the form of direct credit lines, and
b) Entitlement benefits under the welfare state.
In other words, when we monetize government spending – use the money supply to fund a deficit – we build up inflation pressure when a sufficiently large share of that monetized spending goes toward financial transactions.
To find the monetized inflation gap and estimate its size, we first need to formalize our analysis a bit. This is done in Equation 1, where we distinguish between real-sector spending (teacher salaries) and financial transactions (loans to commercial banks and cash payments to citizens). The first pair of variables, mt*Mtd, is the demand for money needed for real-sector transactions in the private sector. Next, md*D is demand for money to fund the government deficit. Lastly, LE is demand for money supply as central-bank credit lines to financial and non-financial corporations:
This equation gives us the most formal expression we need for our analysis. Now, though, let us reformulate it as money supplied by policy purpose. This means, simply, that we say “money is printed for these various forms of use in the economy”. This helps us see how fiscal and monetary policy conspire to create a monetized inflation gap and set the economic stage for high inflation.
Rewriting Equation 1 accordingly, we get:
The four variables on the right hand side represent:
MtS = The share of money supply that is used for regular transactions in the private sector;
MDtS = The share of money supply that is used for government consumption, in other words teacher salaries and other payments where a good or a service is delivered in return for the payment;
MDLS = The share of money supply that pays for government benefits, or entitlements; in other words transfer payments to households (Social Security, EITC) or businesses (corporate welfare);
LE = The share of money supply that is paid out as loans and other cash transactions to commercial banks for the purposes of equity-market investments.
The two variables that interest us the most are MDtS and MDLS, in other words the two that explain how money supply is used to bankroll the federal budget deficit. This is one of the transmission mechanisms from money to inflation.
The Federal Reserve reports (Table H.4.1, Factors Affecting Reserve Balances) that in 2020, their holdings of U.S. Treasuries increased from $2,328.9 billion at the start of the year to $4,672.6 billion as of December 23. That is an increase of just over 100 percent, or $2,344 billion. However, we do not yet have fourth-quarter data on spending and revenue for the federal government. Therefore, we will work with numbers for the first three quarters; again, as of Q3, the total deficit for 2020 was $2,591 billion.
By the end of that period, the Federal Reserve had purchased $2,109.9 billion worth of U.S. Treasurys. This is equal to 81.4 percent of the deficit.
Estimating the gap
We can now establish numbers for MDtS and MDLS. To do so, though, we need to know how much of total federal spending that constituted real-sector spending (for which there is transactions demand for money) and what part was financial transactions. This is easily estimated: in the first three quarters of 2020, the federal government spent a total of $5,309 billion, of which 70.1 percent consisted of financial transactions.
Using this figure, we can establish that
MDLS = $2,109*0.701 = $1,478.3 billion,
MDtS = $2,109*0.299 = $ 631.6 billion.
We still don’t know exactly how much newly printed money went into the financial transactions under MDLS, but we are getting there. First, we need to put a number on the last variable in Equation 2, namely LE. This is a bit more difficult to do, as there are no established statistical products for it. However, we can make an educated guess.
We start with the Federal Reserve system’s Main Street Lending Program. This comes in at $600 billion, but it is only one vehicle of many that the central bank has created for the purposes of pumping liquidity into banks and businesses. In the spring, the Federal Reserve provided overnight loans to commercial banks worth $1 trillion; throughout the second half of 2020, the banks have steadily utilized approximately $150-200 billion. There are also other programs, established specifically to provide liquidity to banks and non-financial businesses.
Based on these programs, it is not unreasonable to estimate that LE runs in the vicinity of $1 trillion. This gives us an estimate of the cash being pumped out in the economy for the purposes of financial transactions: $2.1 trillion.
Transactions demand for money for the first three quarters is approximately $10,985.2 billion. This is calculated based on GDP and personal-income data, excluding the part that is financed by government social benefits. Adding up the variables in Equation 2, we end up with a need for money (another way of saying “money demand”…) of $13,717 billion.
We are now very close to establishing the monetized inflation gap in the economy. All we need is M1 money supply and the current monetary velocity.
Based on Federal Reserve money-supply data, the cumulative M1 money supply for the first three quarters was $14,486 billion. Since the M1 velocity of money for the first three quarters of 2020 is 0.938 on average, the actual utilization of the money stock runs at $13,588 billion.
This is less than one percent away from our estimate of $13,717 billion. In other words, we now know that Equation 2 is a good tool for the calculation of the monetized inflation gap. Going back to that equation, we isolate (again) the share that constitutes financial-transactions supply of money. This, again, is the share of money supply that creates a monetized inflation gap in the economy.
This share of money supply is $2.1 trillion. In other words, the monetized inflation gap equals 14.5 percent of GDP.
What does this mean in terms of inflation? What rate of inflation can we expect in 2021? To answer this question we need two pieces of information:
- Will the Federal Reserve continue to monetize the economy as it has this year?
- What is the price elasticity of demand in the U.S. economy?
The next issue of this newsletter, due out January 8, will address both these questions and provide an inflation estimate for 2021. A hint: we may see inflation rates in excess of ten percent.