The Uninformed Inflation Debate

Here at the Liberty Bullhorn, we warned already in early January that the American economy is facing up to ten percent inflation before the end of the year. We explained in detail how this originates in the monetized inflation gap created by excessive money printing.

Last Friday we reiterated this warning, while pointing to the difficulty in timing of inflationary forecasting. We explained that the one transmission mechanism that triggers inflation is locked and loaded but has not yet been activated. However, we noted: it only takes one small change in consumer behavior to activate that inflation trigger. And we are dangerously close to that happening.

In short: we were first, and most precise, in our inflation warnings, and we stand by the entire forecast. We are even more proud to do so now that the rest of the country is beginning to catch up with us. Unfortunately, most of the debate over inflation remains fragmented and tainted by prejudice and conventional wisdom.

Senator Rand Paul (R-KY) is a noteworthy exception. He is on the money (no pun intended) with a brief but pointed comparison of the current path of monetized U.S. budget deficits to Venezuela:

New 1,000,000 bolivar note in Venezuela worth 53 cents. Will US be the next Venezuela with Congress borrowing over $6 trillion in one year?

Judging from the comments on Senator Paul’s tweet, Americans in general do not seem to have the faintest idea of how dangerous our current deficit monetization actually is. That is understandable given that even the Federal Reserve remains behind the curve. To their credit, they have sent a few tiny warning flags up in the air, explaining back in January in their Beige Book:

According to our most recent surveys, both manufacturing and service sector firms saw an acceleration in growth of prices received. Growth of prices paid for inputs increased moderately for service sector firms but slowed slightly for manufacturers. Inflation of prices paid outpaced that of prices received. Many firms reported rising costs of and longer lead times for raw materials, particularly those used in construction.

In this week’s Economic Newsletter we are going to update our subscribers on the transmission of producer-price inflation into the checkbooks of America’s families. This connection is one of the essential components in any analysis of how inflation will accelerate.

To understand that transmission, we need to recognize the role that fiscal and monetary policy play in it. That understanding remains sorely limited, especially among professional economists and policy wonks. As the first of two examples, behold Lael Brainard, Governor of the Federal Reserve, who on March 2 dropped more than a few hints that the central bank is getting worried about inflation. However, his inflation warnings were clearly tainted by conventional economic wisdom, thus leading him to misstate the transmission mechanism that links a monetary expansion to consumer prices:

Inflation is likely to temporarily rise above 2 percent on a 12-month basis when the low March and April price readings from last year fall out of our preferred 12-month PCE [Personal Consumption Expenditure] measure. Transitory inflationary pressures are possible if there is a surge of demand that outstrips supply in certain sectors when the economy opens up fully. The size of such a surge in demand will depend in part on the effects of additional fiscal stimulus, along with any spend-down of accumulated savings, which are uncertain.

Here is what Brainard is saying, in plain English:

  1. “Transitory” inflation means that there will be a peak in inflation that is undesirable and bad for the economy if it becomes protracted.
  2. When a surge in demand outstrips supply, it means that there is spending in the economy the funding of which does not originate in value-creating production. This is what we have referred to here at the Liberty Bullhorn as the “monetized inflation gap”. Why? Because that “outstripping” demand is paid for with printed money via entitlement benefits and other consumer-oriented transmission mechanisms. (See, again, our Economic Newsletter #1 2021 for the analytical foundation of the monetized inflation gap.)
  3. 3. The comment about spend-down of savings is huge. Very, very important. This is exactly what we discussed in our Economic Newsletter #10. This is the “trigger” we are all waiting for, in order to predict when inflation will accelerate. But the good Federal Reserve Governor Brainard is less clear about the nature of this transmission mechanism than we are.

With that, we return to Brainard’s comments and an unfortunate intellectual misfire by the good central-bank governor:

But a surge in demand and any inflationary bottlenecks would likely be transitory, as fiscal tailwinds to growth early this year are likely to transition to headwinds sometime thereafter. A burst of transitory inflation seems more probable than a durable shift above target in the inflation trend and an unmooring of inflation expectations to the upside. When considering the inflation outlook, it is important to remember that inflation has averaged slightly below 2 percent for over a quarter-century. In the nine years since the FOMC’s announcement of a 2 percent inflation objective, 12-month PCE inflation has averaged under 1-1/2 percent. Readings of 12-month inflation have been below 2 percent in 95 of those 109 months.

When he talks about fiscal tailwinds and headwinds, he really means “Congress has no problem churning out monetized spending now, but they won’t be doing that for much longer”. He is correct in tying monetized spending – although he does not use that term explicitly – to inflation, but he is incorrect in forecasting a shift in the desire for more federal outlays going forward.

From the viewpoint of sound economic thinking, it is downright mad to continue to pump out entitlement spending like Congress has been doing over the past year, but it is equally mad to believe that they will turn off the pump. Governor Brainard thinks like an economist, even an econometrician, but this is a case for political economy:

  • a) Congress operates by a different standard of rationality than economists in general;
  • b) For Governor Brainard’s prediction to come true, the spending that Congress has been engaged in would have to be transitory in intent;
  • c) Most of the spending coming out of all the stimulus bills has been of an implied permanent nature.

In short: the stimulus checks have not been the major items, from last year’s CARES Act going forward. The purpose has been to slowly but relentlessly advance the welfare state, be it in the form of permanent cash handouts (we are now precipitously close to an established basic-income program) or expanded, government-provided health care. When permanent spending grows, there is no transitory intent behind it. Therefore, Governor Brainard is either naive or fundamentally misinformed about the nature of the fiscal policy currently coming out of Congress.

Since the spending we see for the most part has a permanent intent behind it, we can also expect the “fiscal tailwind” to remain. More spending will come – and with it more monetized deficits. Therefore, it is also hugely important to not use the historic basis that Brainard refers to, as a basis for inflationary predictions. That forecast comes loaded with implicit axioms (unspoken and probably unwanted assumptions) that taint your forecast.

To be blunt: one such implicit axiom is the intent behind fiscal policy: during the nine years that Brainard refers to, the intention behind fiscal policy was not to put Modern Monetary Theory to work. Today, the Biden administration and the Democrat majority have put MMT to de facto use as a theory for more deficit spending; wherever MMT is put to work, government abandons its concerns about inflation. As Senator Paul points out, the result was most recently put on conspicuous display in Venezuela.

The problem for Governor Brainard and others hoping for a “transitory” inflation peak is that they treat politics and ideology as water-tightly separated from fiscal policy and the economy. This is the same mistake that underpins model-based forecasting, as referred to by Brainard in the next paragraph of his March 2 remarks:

According to recent research, statistical models estimate that underlying core PCE inflation ranges from one- to four-tenths of 1 percentage point below our 2 percent longer-run target. Recall that at the end of 2019, with unemployment at a multidecade low and after the addition of almost 1-1/2 million workers to the labor force during the previous year, PCE inflation was 1.6 percent for the year.

Again, MMT had not been made the doctrine behind welfare-state expanding fiscal policy. Econometricians who make these models are almost universally unable to include such policy variables in their models. This is not for lack of aptitude among model programmers; the reason is simply that policy preferences do not easily lend themselves to econometric forecasting. Without a thorough understanding of political economy, it is not possible to fuse traditional economic forecasting with policy variables such as MMT and welfare-state expansion.

In short: the Federal Reserve will continue to tell us that the coming rise in inflation will be transitory because their models – not reality – tell them so.

Unfortunately, this naivité in the face of the inflation threat is not limited to professional econometricians. Which brings us to our second example of how limited the understanding of inflation is in the economics profession. Explains economics professor Alexander Salter of Texas Tech University in a March 3 op-ed for the Washington Examiner:

The fundamental cause of inflation, always and everywhere, is “too much money chasing too few goods.” When the money supply grows faster than economic productivity, we get inflation.

This is not true. Money supply has been outgrowing productivity gains in the U.S. and European economies for over a decade now, and on neither side of the Atlantic have we seen anything more than marginal inflation.

Then Salter turns his attention to deflation, offering the standard Austrian-theory jab at Keynesian economics:

Contrary to Keynesian fever dreams, deflation isn’t always a bad thing. When the economy grows more efficient, when we get better at taking labor and capital and transforming them into goods and services, the natural consequence is for prices to fall. This kind of deflation is benign.

The good Professor Salter is right, in a very narrow sense. However, given his somewhat casual use of the term “deflation”, may I recommend – without delving into the depths of economic theory – that he study up on the differences between the Pigou and Keynes effects on real wages.

Anyway. Back to his argument that inflation is not something we need to worry about:

Can a big boost in federal spending generate inflation? It’s possible, but unlikely. For the stimulus package to drive up prices, at least one of the following must happen: The money supply must increase, or the rate of turnover of the money supply, how fast dollars change hands, must increase.

And as we have repeatedly explained, that is exactly what has happened. We have also reported carefully on the transmission mechanisms by means of which that money supply finds its way into consumer prices. None of that is even touched upon in Professor Salter’s op-ed.

Even more than that, he suggests – remarkably – that there is no connection between monetary and fiscal policy:

The Federal Reserve isn’t responsible for the stimulus package, so it’s not going to be a money supply issue.

We have to be respectful here and refrain from asking certain questions about the foundations of Professor Salter’s analysis, but we nevertheless have to note that over the past year the Federal Reserve has doubled its holdings of U.S. debt. Do we need a clearer indication of how inextricably monetary and fiscal policy have been tied together?

Professor Salter refrains from seeing these ties. Instead, he actually hints of the analysis we do here at The Liberty Bullhorn of the inflation “trigger” embedded in consumer finances:

If inflation happens, it must lie behind door number two. There’s some support for this; a big injection of public cash might prompt increased private spending. Then again, it might not. Previous rounds of spending, which included checks for households, haven’t stoked an inflationary fire. Families saved a large amount of their COVID-19 bucks, which resulted in a much higher private savings rate, along with stronger household balance sheets.

Again, we discussed this in detail in last week’s Economic Newsletter, explaining what it takes for this trigger to spark a bonfire of high inflation, possibly even hyperinflation (if Congress remains committed to MMT).

Then Professor Salter makes the standard prediction – same essentially as Federal Reserve Governor Brainard above – of how any inflation we may see, will be transitory or insignificant, or both:

Now, all the problems are on the supply side. No amount of economic “stimulus” can solve the problem of labor and capital staying home. Once we make more progress on the virus, things will really start to pick up. What does all this mean for inflation? Short answer: not much. Don’t expect big price increases if the Democrats have their way. The stimulus package, quite the misnomer, won’t put more dollars into circulation, and it won’t much increase the rate at which dollars are spent. If inflation occurs down the road, it’ll be because of the central bank, not the Biden administration.

So, dear Professor Salter, how exactly will the central bank’s money printing make its way into consumer prices?

With the public debate over inflation being still fragmented and largely uninformed, the best America can do is to stick with the Liberty Bullhorn. Here, we do our homework before we speak. Get a subscription and stay informed like many others already do! Get it today – we are soon going to expand our subscriber-only section and scale back the number of free articles.