Inflationary Policy Must Show Up in Accelerating Domestic Spending
The inflation process is one of excess money driving excess demand across goods and service markets, providing the wherewithal to pay higher prices and interest rates at the same time that it creates the impetus for these. There is no current disagreement among economists on this. Rather, the debate more typically revolves around what is the best indicator of excessive money: the money stock, interest rates, or prices of gold or other sensitive commodities? Fortunately, there is no need to resolve this debate.

Whether it is best depicted by rapid money growth, excessively low interest rates, or rising gold prices, inflationary money drives inflation by inciting faster growth in total spending. The Quantity Equation is the embodiment of the macroeconomic principles discussed here. M*V = P*Q: Money times Velocity equals Price times Quantity (of real Output). Excess money—too much M—drives general excess demand which initially might drive a stronger economy—higher Q—but eventually leads to inflation: rising P.

If the velocity of money, V, were sufficiently stable, then the money stock would be the reliable indicator of monetary policy. Higher M would eventually lead to higher P, and any sustained increase in P would have to be driven or validated by sustained growth in M. Now, financial technological factors might distort the behavior of the money stock itself, but they don't invalidate Walras' Law, nor the monetary nature of inflation, nor the Quantity Equation. If supposedly inflationary monetary policy is not showing up in the money stock, then it should be showing up instead in higher velocity of money, leading to the same acceleration in total spending (P*Q) that the money stock would drive in the absence of distortions.

Again, inflation is too much money chasing too few goods. The sure-fire indication of such "chasing" is aggregate nominal spending. If spending isn't accelerating across the economy, one can't sustain an argument that policy has been inflationary within the relevant past.

Total spending is measured by nominal GDP: total dollar-value transactions on final goods and services produced in the U.S. Look at the history of the last fifty-five years depicted in Exhibit 1. The Fed did pursue inflationary policies from the early-1960s through the late-1970s, and that policy resulted in rising inflation from about 1965 through 1980. That inflation was preceded by and accompanied by a sustained accelerating trend in aggregate spending starting in 1964 and peaking in 1979. Spending growth still showed cyclical fluctuations during that period, but the trend, again, was ever higher. Similarly, the disinflationary policies followed by the Fed starting in August 1979 were followed shortly thereafter by a secularly declining trend in spending growth over 1980-1995 and stable spending growth ever since, with similar trends in inflation.

Even during the inflationary era, there was disagreement as to whether or not Fed policy was to blame for rising inflation. Some economists regularly argued that interest rates were not excessively low and that money stock data were misleading. Gold prices were pegged until August 1971, so gold failed—perforce—to signal the onset of rising inflation in the mid-1960s. Quibbles about Fed policy then could have been dispelled had one merely cited the ongoing, secular acceleration in nominal spending that was clearly in place by the late-1960s and that continued throughout the 1970s. Similarly, during the disinflation era, periodic debates about whether Fed easing had been excessive or not—based on occasional spurts in money, declines in interest rates, or rallies in gold prices—could have been correctly resolved by citing the ongoing decelerating trend in nominal spending.

Whether easy money is best reflected by rising M or V, inflationary policy should show up directly in accelerating total spending. Granted, there are lags from swings in policy to their full reflection in spending and further lags from spending swings to their full reflection in inflation. However, it cannot be correct to assert mounting or waning inflation pressures presently if nominal spending is not validating those claims. Similarly, even if one is merely asserting the presence of inflationary policy presently, those claims would have to be affirmed by faster spending before they could be expected to show up in inflation.

Nominal Spending Is Decelerating Presently
As seen in Exhibit 1, total spending has not exhibited much change in trend in this decade, and, as seen more clearly in Exhibit 2, if anything, total spending has been decelerating since early-2006, especially so in recent quarters, where spending growth has been only 3%. With the economy growing normally at a trend real rate of 3.0% to 3.5%, even the peak 6.5% spending growth rates of 2004-2005 would be consistent with underlying inflation of only 3.5%-3.0%, and present nominal GDP growth of 3%, if sustained, would be consistent with zero or negative inflation.

So the worst one could say about inflation presently is that overly easy policy back in the early-2000s is driving a temporary burst of 3.0%-3.5% inflation presently, with that pace set to decline sharply as tighter policy and slowing spending more recently start to take hold. Even this assertion is strained because it relies on a much longer lag from spending to inflation presently than has been observed in the past.

Why Isn't Inflation Declining Presently? It Is!
Allowing for more typical, shorter lags from spending to inflation, one would expect that inflation would be slow and declining presently. This is, in fact, what is happening. Common inflation measures such as the CPI are flawed on at least two counts. First, the CPI measures prices only in the consumer sector, not across the economy, and, as we have asserted, inflation is a pandemic process, not a localized one. Second, commodity weights in the CPI are fixed. They don't adjust the way spending patterns in an economy adjust in response to commodity shocks. These real-world adjustments allow not only the maintenance of full employment in the face of a shock, but also the sustenance of stable absolute prices in an otherwise non-inflationary environment. On both these counts, the CPI overstates the effects of relative-price changes and so misstates inflation.

On these grounds, the best indicator of inflation trends is the GDP deflator. As seen in Exhibit 3, the GDP deflator has been slowing for two years and is growing barely above 2%, with lower rates inflation likely in the near future (given the downtrend in spending growth). The GDP deflator measures the aggregate price levels of all goods and services produced in the U.S.: all items within GDP. Furthermore, the weights of various goods and services in the GDP change over time with spending patterns, which is exactly what they should do in order to accurately—but not excessively—reflect the impact of relative price changes on the absolute price level.

Keep in mind that this is a headline inflation measure. It includes food and energy prices in proportion to their importance in U.S. production. While oil and food prices have seen relative price increases in recent years, prices of other goods and services have fallen relative to previous trends, so as to allow total inflation as per the GDP deflator to decelerate steadily.

Again, nominal GDP and the GDP deflator measure total spending on and aggregate prices for all goods and services produced in the U.S. One might counter that with prices of imported oil rising so rapidly, we should look at spending and prices for all goods purchased by Americans, rather than that for all goods produced by Americans. The response to this contention is twofold. First, it has been emphasized here that inflation is a pervasive, economy-wide phenomenon. Within that context, it is untenable to claim that there are domestic price pressures if those pressures are showing up only in import prices. Even so, we can address these concerns by subtracting the trade balance (net exports) from GDP to get domestic demand. Both nominal spending and deflators under this concept tell essentially the same story as that detailed here for nominal GDP and the GDP deflator.

Inflation Indicators Presently
"Inflation is the order of the day...The discount rate will probably be lowered at the next meeting of [the Federal Reserve]...There is reason to expect that all attempts to curb inflation and hamper credit expansion...will meet with general opposition. Inflationary ideas have seriously taken hold of many minds in financial circles." H. Parker Willis, January 1932, as quoted in Friedman and Schwartz (1963, p.407)

We've seen here that there is no macro-evidence of inflation pressures at present in the U.S. and that comprehensive measures of inflation are indeed decelerating. Yet popular sentiment—not just in the media—is that inflation is rampant. This is not that unusual. Even in a stable-price environment, there will be some prices rising and some falling, and it is human nature to seize on the rising ones and link current experience to inflation episodes of the past (especially if rising oil prices are part of the equation).

Much the same sentiments were in play in the 1930s. In the midst of an implosive deflation, some commentators saw belated attempts by the Fed and federal government to counter the Depression as parallel to the policies that drove inflation during World War I. Mr. Willis, quoted above, was a supposed monetary expert who had been instrumental in the drafting of the Federal Reserve Act of 1914. Yet, even a man of his eminence completely misjudged the events of the time. As obvious as it was to Willis and others that the U.S. was inflating in 1932, instead, deflation continued for another five years.

Some of the economic details extant presently differ from those of the early-1930s, but the similarities are striking, including the presence of a banking crisis, criticism of Fed efforts to contain crisis as being inflationary, upward pressure on gold prices, and a weak economy accompanying these developments.

Meanwhile, popular perception to the contrary, the differences between the present environment and the 1960s and 1970s are equally striking. By the late-1960s, inflation was already rampant across the economy, in both core and headline price measures. Prices were rising in every retail sector. Labor costs were steadily accelerating, reaching an 8% rate by 1969. These events occurred at the tail end of a decade of extremely rapid economic growth, and, as seen earlier, constant acceleration in nominal spending. Inflation became even more pronounced and rampant in the 1970s, but, even by the late-1960s, it was already pervasive and entrenched.

In contrast, presently, while the headline CPI has picked up, core measures have not. Prices are still declining in more than half of the retail sector. Labor costs are growing only 3% and decelerating. Economic growth in this decade is the slowest on record, with nominal spending, if anything, showing a decelerating trend recently.

Despite the media drumbeat, break-even inflation rates on TIPS remain in the low 2% range, failing to rise significantly recently (Exhibit 5). Then there are home prices. Gold is the inflation hedge for a few true-believers, but housing is everyman's inflation hedge. Home prices were rising in the 1960s, long before gold began its climb, and they continued ever-upward through the 1970s. As we know all too well, home prices are plummeting presently.

Inflation fears were similarly common in the 1930s, in the wake of the 1987 stock market crash, and in the advent of Y2K. All those past fears and others proved to be unfounded, and the evidence presently indicates that current fears are similarly misguided, no matter how confidently they may be asserted.

Energy and Food Price Pressures
None of this disparages the importance of demand/supply imbalances in food and energy. The opposite is true. To the extent that food and oil prices reflect real problems in the energy and farm sectors, they are NOT indicative of monetary imbalances. Their successful address will require concerted conservation efforts by consumers and increased production efforts by suppliers, not concerted Fed tightening.

The energy shocks of 1973 and 1979 occurred eight and fourteen years into an inflation cycle and partly in response to the inflationary pressures building elsewhere. What's more, those shocks were abetted by the effects of wage and price controls. A reversal of inflationary policies and removal of energy price controls went a long way toward reversing the energy crisis then, though private-sector adjustments also helped.

Presently, oil and food shocks are occurring within an environment where prices are flat or falling in most of the rest of the economy, where nominal spending is slowing, and where no government controls are hampering market performance. It is likely that more substantive real-world adjustment will be necessary now than was required in the 1970s and 1980s. Oil demand in China and India alone has risen nearly by 10 million barrels per day since 1995, and world energy usage needs to adjust to this reality as well as to similar changes in food demand. However, this is a far cry from describing current events as inflation.

What Liquidity Injections?
With rate cuts, establishment of the TAF and TSLF facilities, and other actions, the Fed has moved aggressively to counter recent credit market meltdown. Some claim that it has overdone this to the point of an inflationary response, pumping in massive amounts of liquidity that will drive inflation. First, keep in mind that even if this were true, there is no way that actions since last summer could be affecting prices presently. Second, credit crises are deflationary events. In terms of the Quantity Equation discussed earlier, credit crises cause individuals to horde cash assets, driving a lower velocity of money, possibly even a decline in the stock of money, should widespread financial institution failures occur. So, with credit market distress in place, a monetary policy stance that might otherwise be inflationary is necessary merely to offset the deflationary effects of the crisis. (The Fed failed to counter depression in the 1930s, and even those actions were criticized by some as inflationary, as we have seen.)

Third, while the Fed has indeed tried to negate the effects of the credit crisis, no injections of liquidity have occurred. The monetary base is the cumulative sum of all liquidity injections ("pump-ins") by the Fed. It has been dead flat throughout the credit crisis, in fact, showing even slower (zero) growth since the crisis.

The flat level of liquidity flatly contradicts contentions of massive liquidity injections by the Fed. The Fed has not expanded its balance sheet in response to the current crisis. It has taken existing systemic risk onto that balance sheet, but that is not even an expansionary action, let alone an inflationary one. In some previous crises, reserve injections did occur, and one had to wait to view nominal spending trends in order to verify that higher M was offset by lower V. In the present crisis, however, there has not been ANY growth in total liquidity, and so there is even less reason to think that the Fed is turning the present deflationary situation into an inflationary one.

Even with respect to interest rates, while Treasury rates have plunged, spread widening has left most private-sector borrowing rates as high as or higher than before the crisis. It is doubtful whether lower Treasury rates alone will drive higher velocity and, so, faster spending growth. For now, the facts remain that total spending is slow and slowing, and there have been NO offsetting liquidity injections.

Besides the issue of how best to detect easy money, another debate among economists is whether Fed policy has instigated past inflationary pressures or whether it merely accommodated cost/price pressures brewing in particular sectors, allowing them to become pandemic. Recent Fed statements about keeping inflation expectations "anchored" can be understood within this debate. The Fed is warning that it will not accommodate pressures from the energy and food sectors. As we have seen already, they certainly have not accommodated nor instigated these pressures in the past three years.

Conclusions
Inflation is a monetary phenomenon, and money is liquid, pervasive. If there were too much money chasing too few goods at present, that chasing would be occurring in virtually all markets, not in only a few. Price increases presently are dramatically more narrowly-focused than they were either early in the inflation prices in the late-1960s or later in that process in the 1970s. Whatever your preferred measure of choice of monetary policy, easy money hits the economy via accelerating total spending, and the total spending data unequivocally argue against the presence of domestic inflationary pressures in the U.S. at present. In line with this, the price indices that are most comprehensive and representative of inflation pressures are decelerating presently, and spending trends point to still-lower inflation near-term.

Panicky inflation stories make for good financial-media theater, and they appeal to those suspicious of official price data. However, in the cold light of day, the evidence weighs firmly against them. Granted, the U.S. and global economies may be facing serious demand/supply imbalances in food and energy sectors that will be with us for years. However, this voids these problems as evidence of inflation, rather than marking them as such.

The Fed certainly has the capacity to engage in inflationary policy, and the right (wrong?) mix of political pressures and policy operatives down the road may well lead to a resurgence of inflationary pressures across the U.S. economy. However, current and recent policy actions do not point to such developments, and popular cries of inflation, though plaintive, are misjudged. The pain is for real, but associating it with inflation is incorrect.

References

• Friedman, Milton and Anna Schwartz (1963), A Monetary History of the United States 1867-1960, Princeton University Press.

Footnotes

1. Growth in nominal domestic demand peaked in late-2005 at a rate of 7% and has since decelerated to 3% growth in Q1 2008, essentially the same path as seen for nominal GDP. In line with this slowing trend in such spending, the deflator for domestic demand peaked at a trend rate just below 4% in late-2005 and has generally been declining ever since. Being more sensitive to oil prices than the GDP deflator, the domestic shows short-term chop—alongside short-term oil price swings—than the GDP deflator, but it shows the same ongoing decelerating trend. Furthermore, just as there are lags from monetary policy to inflation, so too one could expect that there are lags between oil-price hikes and declines in prices in the rest of the economy. Thus, it should not be surprising that ongoing trends in the domestic demand deflator are temporarily interrupted by swings in oil and, possibly, food prices. The fact remains that nominal domestic demand continues to decelerate, and this signals an ongoing downtrend in the deflator for this aggregate, as per the analysis in the text.