Hindsight 2020: The Inflation Legacy

I have written at length about the threat of monetary inflation, and I will continue to do so. This Friday I will publish the next issue of my Economic Newsletter with yet more analysis of the threat of monetary inflation; click here for a $2.99/month subscription and get the first issue with a comprehensive estimate of just how big the threat is of money-driven inflation.

Some writers are beginning to give the threat of inflation some attention. One of them is Richard Rahn, a good economist and veteran political commentator. In an article in the Washington Times, Rahn lays out the case for a possible return of inflation. Noting the excessive rise in money supply this year, Rahn makes the logical connection to rising consumer prices. So far, he says, the monetary excesses have not produced inflation because

most people increased their savings rate (reducing money velocity), and by saving rather than spending, inflation was avoided.

But, he asks:

What will happen as the economy begins to return to normal as the pandemic subsides? As restrictions on shops, bars, restaurants, travel, etc. are lifted, there will be big surge in demand for the previously restricted goods and services. At least temporarily, demand will likely exceed supply as businesspeople struggle to respond. The velocity of money will increase and over time should approach the long-term trend. 

This is a correct observation of some of the economic mechanics that turn monetary expansion into inflation. However, the rise in velocity that Rahn points to is not a driver of inflation per se. It is only a technical matter: monetary velocity is the ratio of money supply to current-price GDP (theoretically the transactions demand for money). In other words, to understand where inflation comes from we need to find the cause of a rise in velocity. Rahn makes a point to that effect:

In order to avoid inflation rising at a destructive rate, policymakers at the Fed, the administration and Congress will need to extinguish the excess money created during the pandemic at a rate to offset the rise in velocity. Normally, this would require an increase in interest rates and a reduction in government spending. But the folks at the Fed have said they do not plan on increasing interest rates, and it is difficult to imagine that Congress and the new administration will do anything even remotely serious about reducing spending.

Here, Rahn points to the real transmitter of monetary inflation: government spending, but he does not go into detail about just how forceful this transmission mechanism is. (That’s only logical – his article is an op-ed.) I do just that in the first issue of my Economic Newsletter, where I explain in statistical detail how this transmission happens. I estimate the monetized inflation gap in our economy, pointing to a money-driven pressure on prices that is equal to 14 percent of GDP. In the coming issue, out this coming Friday, I estimate the level of inflation that this monetized gap is likely to cause.

The inflation mechanism that Rahn zeroes in on is the tension between supply and demand. When people can start spending money on consumer goods, he says, inflation will tick up because suppliers will have a hard time getting goods and services out the door. This point deserves a lot more attention than it is getting, specifically because there are two variables at work here, creating a dangerous, if not explosive inflation scenario.

The first variable is the injection of money through government spending. As I explain in detail in my Economic Newsletter, this severs the ties between supply and demand in the economy. This is a different phenomenon than the traditional dynamics between supply and demand; we must separate demand-pull inflation (a regular business-cycle rise in prices) from monetary inflation, which is what we are about to encounter. When government injects newly printed money into the economy, the situation Rahn describes, with supply not keeping up with demand, becomes far more explosive, much faster.

Again for reasons I explain in my newsletter, monetarily driven inflation, unlike demand-pull inflation, has no countervailing force to dampen it. Therefore, the injection of money into the economy is extremely dangerous with reference to inflation.

But that is not the only inflationary risk factor. The second one is embedded in the supply side of the economy and related primarily to employee compensation. Currently, our economy has a built-in pressure on prices that comes from wage increases. As I explained yesterday, average weekly wages are rising in a way that normally does not happen when demand for labor is down. Figure 1 reports annual-rate increases for the aggregate private sector of the economy. Notice the red segment:

Figure 1

Source: Bureau of Labor Statistics

This increase can be explained by the fact that employers value the employees they retained after reducing their payrolls due to the artificial economic shutdown last year. As I explained yesterday, most of the private sector has yet to recover the jobs they cut earlier in 2020, but they have made sure to keep compensation up for those employees the have retained.

The big question, of course, is whether or not the high wage increases from 2020, reported in Figure 1, will sustain going into 2021, and whether or not that will put inflationary pressure on production costs, i.e., create supply-push inflation. The answer begins in Figure 2, which compares the annual growth rates (reported weekly) for average weekly paychecks and the total cost of those paychecks, i.e., the average paycheck multiplied by the number of employees. The result is quite interesting, especially if we compare 2020 to the 2009-2010 Great Recession. Back then, average and total wages trended largely in the same direction. That was not the case last year:

Figure 2

Source of raw data: Bureau of Labor Statistics

The conclusion from Figure 2 is that:

a) if average wages sustain at its current, high growth rates, and

b) they do so even as employers start adding new jobs,

then yes, we will get supply-side inflation. We will also get inflation through the mechanisms that Richard Rahn points to.

But will we? What is the statistical case for supply-push, demand-pull and monetary inflation? This week’s Economic Newsletter will have the numbers to answer that question. In our current, uncertain economic times, this is information that every economic decision maker must have. Subscribe today – only $2.99/month – and get exclusive access to original economic research not available anywhere else.