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Is Powell Right About Inflation?

Summary:
If we believe what its chairman is saying, the Fed does not seem to know what inflation is. The Wall Street Journal of Friday wrote (Nick Timiraos, “Powell Says Supply-Side Constraints Have Worsened, Creating More Inflation Risk,” October 22, 2021): “Supply-side constraints have gotten worse,” Mr. Powell said Friday at a virtual conference. “The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation.” The economic definition of inflation is a sustained or persistent (not transitory)  increase in the general price level as the Journal hinted to just before the quote above, but it is not clear if it was paraphrasing Mr. Powell. What is pretty sure is that inflation cannot be caused by mere “supply-side constraints,” except if

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If we believe what its chairman is saying, the Fed does not seem to know what inflation is. The Wall Street Journal of Friday wrote (Nick Timiraos, “Powell Says Supply-Side Constraints Have Worsened, Creating More Inflation Risk,” October 22, 2021):

“Supply-side constraints have gotten worse,” Mr. Powell said Friday at a virtual conference. “The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation.”

The economic definition of inflation is a sustained or persistent (not transitory)  increase in the general price level as the Journal hinted to just before the quote above, but it is not clear if it was paraphrasing Mr. Powell. What is pretty sure is that inflation cannot be caused by mere “supply-side constraints,” except if those increase over time. Suppose that production (GDP) decreases by 5% in one year, that it stays at this new level, and that the Fed keeps the money supply constant (and that people do not demand more money in preference to other assets). We would then expect an increase of 5% in the general price level, but this would be only a one-year affair: the higher prices would stay at their new level and would not continue to increase by 5% every following year. For this increase in the general price level to be sustained, production would have to continue to decrease by 5% every year. Or the Fed would have to continue increasing the money supply by the same proportion every year.

From February 2020 through August 2021, while production dipped and recovered, the money supply (measured by M2) increased by 34% (see chart). This is equivalent to an annual growth rate of 21.8% and no end is in sight. No wonder why so many economists expect the annual rate of inflation to continue if not to increase—until the Fed stops boosting the money supply. Note that “long and variable lags” are involved, as Milton Friedman is reported to have said. Is Powell Right About Inflation?

Blaming inflation on “supply-side constraints” looks like a cover-up by the Fed, which previously tried to make us believe that its money creation in response to federal deficit financing could not cause inflation, contrary to what economic theory predicts and history frequently confirmed. A Wall Street Journal op-ed by Steve Hanke of John Hopkins University and John Greenwood explains inflation with a plumbing metaphor that some may find too scientistic, but which does illustrate the phenomenon (“The Monetary Bathtub Is Overflowing,” October 21, 2021).

We are not in Germany after WWI, Zimbabwe, or Venezuela, but it would be prudent to recall that some roads lead there which are paved with good intentions.

According to the WSJ,

Mr. Powell said it would be important for the central bank to stay flexible in the months ahead. The central bank will “need to make sure that our policy is positioned for a range of possible outcomes.”

This reminds me of what I heard from a politician in the 1970s—if my memory serves, it was California governor Jerry Brown: “What we need are flexible policies for an ever-changing world.” Useless at best, dirigiste at worst!

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