Cumberland Advisors Market Commentary – Inflation?

Author: Robert Eisenbeis, Ph.D., Post Date: August 19, 2020
image_pdfimage_print

During an August 14, 2020, lecture at the Center for Financial Stability, Charles Goodhart (former member of the Bank of England’s Monetary Policy Committee and professor at the London School of Economics) mused about the US’s current economic slowdown and the prospects for inflation that might result because of the extraordinary increase in the money supply that has occurred (http://centerforfinancialstability.org/research/Goodhart_Deflation_Inflation_081420.pdf).

Cumberland Advisors' Robert "Bob" Eisenbeis, Ph.D.

After reviewing history, Goodhart turns to a discussion of where we are now. He makes three points. First, policy is currently expansionary, with low interest rates. Second, the pandemic has resulted in a shock to both aggregate demand and supply, and the path of the recovery is as yet uncertain and critically dependent upon a vaccine. Third, inflation will remain low for a long time. However, he then notes Milton Friedman’s classic observation that “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” (Milton Friedman, “The Counter-Revolution in Monetary Theory,” IEA Occasional Paper No. 33, 1970; https://miltonfriedman.hoover.org/friedman_images/Collections/2016c21/IEA_1970.pdf

Goodhart notes that monetary growth has surged by some 32% in early 2020, and to a monetary economist this means that future inflation is almost a certainty. The timing is uncertain and depends on what happens to the velocity of circulation. As the chart below shows, the decline in velocity in the short run has offset the money supply increase, due in part to a large increase in precautionary saving and a drastic cut in aggregate demand for many goods and services. 

Inflation-Fred-Chart-Eisenbeis
To Friedman, this was a natural response encoded in Irving Fisher’s equation MV=PT (money times velocity equals prices times the volume of transactions). In current terms the increase in money has largely been offset by a decrease in the volume of transactions, with little impact on prices. However, Friedman notes that during inflationary periods with rapid expansion of demand, velocity tends to increase in lockstep with the money supply. We would note, too, that we have not seen such a sharp drop in velocity nor such a sharp rise in the money supply since WWII. Both factors represent ominous prospects for monetarists. 
 
Goodhart then speculates as to what policy options might be available should the economy recover and policy need to be changed to prevent the inflation that many economists fear is inevitable. He suggests that options that involve increases in interest rates, either directly by tightening policy or by letting central bank balance sheets run off. Both of these options, he argues, are fraught with political constraints, either to keep the costs of debt financing down or to avoid the increase in debt levels that will put further pressure on debt markets. 
 
Not mentioned in Goodhart’s paper is the issue of how high interest rates might have to go to dampen inflationary pressure – which is likely to be high due to the sheer volume of reserves that have been put into the system – if the Federal Reserve insists upon using only its current interest-rate policy tools and open-market operations. The alternative in the short term, as we have argued previously, is to use reserve requirements to temporarily sterilize the ability of the banking system to expand credit and the private-sector money supply to meet the growth in demand that will accompany an expansion. Using reserve requirements and differential interest rates on required and excess reserves would reduce the extent that interest rates would have to be increased to address inflationary pressure, because it would involve working on the margins rather than on the total volume of outstanding credit. For example, with high reserve requirements, a higher rate on excess reserves than on required reserves would tend to discourage too rapid expansion and not involve the radical movements in interest rates that a pure interest rate policy would require.
 

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites. Sign up for our FREE Cumberland Market Commentaries Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.

cumber map
Cumberland Advisors® is registered with the SEC under the Investment Advisers Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in the states where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services. Please feel free to forward our commentaries (with proper attribution) to others who may be interested. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.
Loading...