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Is high inflation heading our way? Many economists predict so. Others say not to worry. So what’s this all about, and who is right?
Since February of last year, the Federal Reserve has increased the money supply by an unprecedented amount—approximately 26%. This upsurge of money creation is warranted given the weakness of the economy. In the aftermath of COVID-19, overall spending on goods and services collapsed. In response, the Fed increased the money supply to increase spending and counteract the fall in demand.
This explains why the massive increase in the money supply hasn’t caused inflation. Indeed, the inflation rate is only 1.4%, below the Fed’s target of 2%. Although the money supply exploded, the rate that people spend money—what economists call the velocity of money—has fallen by about the same amount.
Moving forward, the interesting question is, what happens as the economy recovers and velocity rises? Sure, households and firms last year were reluctant to spend money given all the uncertainty. But over time, spending habits go back to normal. Economists from David Hume in the 1700s to Milton Friedman in the 2000s have noted that, in the long run, an increase in the money supply causes the price level to rise by a proportional amount. In other words, the 26% increase in the money supply will eventually cause prices to rise 26%. Assuming velocity rises back to normal slowly over the next six years, we’d expect an average yearly inflation rate of over 4%.
Inflation is certain to rise unless the Fed removes some of the newly created money from circulation as velocity rises. This would prevent inflation, and it’s exactly what the Fed should do. But that doesn’t mean the Fed will manage this in a timely manner.
Given the low inflation of the last decade, the Fed has explicitly communicated a desire for higher inflation. So as inflation starts rising, the Fed will welcome it at first. But at some point, increased spending might push up the inflation rate rather suddenly, catching the Fed by surprise. And if inflation starts rising faster than expected, the Fed will be reluctant to tighten monetary policy for fear of slowing the recovery.
It is completely reasonable to predict that inflation will rise above 4% in the next five years. The Fed has been begging for higher inflation—but be careful what you wish for.•
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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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