Posted by Inflation has been a keyword lately, especially when the Fed has been printing dollars non-step for the past year.
But what is inflation? How much inflation is too much? This post aims to give an in depth discussion on these topics.
What is inflation?
Let’s start with the definition of inflation. The official definition of inflation in economics has undergone some changes throughout history. In this post, we’ll be using a more common and modern day text book definition, which is roughly: Inflation is the general increase in prices of goods and services, and thus a general decrease in the purchasing value of money.
In the quantity theory of money, the equation of exchange gives us:
M x V = P x T, where
M = The total nominal money supply
V = The velocity of money
P = Price level, this is the key indicator of inflation
T = The number of financial transactions
So, assuming the number of financial transactions is the same, then an increase in P (Inflation) is simply an increase in M x V, i.e., inflation is a product of increasing total money supply times the velocity of money. (The velocity of money is the rate at which money is exchanged in an economy.)
With that, we can formally define inflation as the increase in general price levels.
What is hyperinflation?
One important thing to clarify before we jump deeper into the discussion here is that inflation is good for an economy, but hyperinflation is bad.
These days, whenever inflation is brought up, people immediately think about hyperinflation, conjuring up images in their minds of stacks of useless cash pushed around in wheelbarrows. Just to be clear, the official definition of hyperinflation is 50% month over month increase in prices, which translates to around 129x (or 12974.63%) annually. Compared to that, the current 5-6% annual inflation rate is pretty low.
With that said, let’s discuss what can cause hyperinflation? Luckily, history provides a lot of examples of where hyperinflation struck. In the popular retellings of these events, the story generally goes along the lines of “the government / central bank printed more and more bank notes, resulting in an excessive supply of these notes, which then resulted in their devaluation and thus inflation.”
In my opinion, however, this description is incomplete. It leaved out one very important step, which is to distribute the printed money via government spending (i.e., fiscal policy). This mass distribution of money will result in the increase of money supply (increase of M in the equation above), as well as the increase of money being spent and circulated (increase of V). And that will eventually trigger hyperinflation.
Simply put, it is not “printing money” that is the problem, but the attempt at creating “value” out of thin air – by printing bank notes not backed or offset by anything, and then spending them as if they were valuable.
What is quantitative easing (QE)?
Actually, quantitative easing is a big topic, and we won’t go into the details of this in this post. But one thing I’d like to clarify is that quantitative easing is NOT simply printing money.
The most recent quantitative easing started in 2009, and has increased multiple times since then, with the latest increase in around March 2020 due to the COVID-19 pandemic. Here is a brief history,
- In the US, inflation from 2009 to March 2020 has been low to very low, generally in the 0-2% range.
- Most other developed nations saw similar trajectories with regards to QE and inflation as the US, though numbers and dates may be slightly different.
- Japan started aggressive monetary policies in the early 90’s, culminating in QE around 2001 – 8 years before most of the other developed nations.
- Japan’s annual inflation rate up to March 2020 has generally been extremely low, with bouts of deflation.
- In March 2020, in addition to aggressive monetary policies by central banks around the world, fiscal policies around the world also stepped up, culminating in a series of transfer payments around late 2020 into early 2021.
- In March 2021, we finally saw inflation pick up in the US.
- Again, most of the world mirrored the US’ experience from 2020.
As the figure suggests, quantitative easing essentially involves central banks buying financial assets, which contributes to the stock and bond surge since 2009. However, that money did not contribute to the velocity of money (V in the equation above), at least not until recently.
I believe that is the reason why, despite starting from a decade ago, QE did not cause the price level to go up. How then, do we explain the high inflation that started around March 2021? Well, Joe Biden happened. Based on his proposal, the US government started massive fiscal policy programs in mid / late 2020. This massive government spending is the direct trigger of the inflation we are seeing right now.
Apply this back to the equation above, before 2020, while M (the money supply) was rapidly increasing, V (the velocity of money) was rapidly decreasing. As a result, the product M x V is actually increasing at a rather slow rate, thus low inflation. But after late 2020, the rate at which V decreased slowed down dramatically but M increased dramatically. As a result M x V started increasing at a higher rate, i.e., higher inflation.
Putting it all together, quantitative easing alone, I believe, won’t cause inflation. The problem lies in the massive government spending. And if this continues, I think we will have higher and higher inflation numbers.
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