Causes of Inflation

Inflation as understood by everyday Americans typically means that prices are going up. Inflation has been the subject of many headlines over the past year, but what are the root causes of inflation?

An increase in the amount of money outstanding is a prime suspect anytime inflation breaks out. However, an increase in the supply of money is not necessarily the reason for inflation! The basic equation for quantity theory is called The Fisher Equation as it was developed by American economist Irving Fisher. In its simplest form, it looks like this:

But before we do that, let’s specify some specific scenarios in which inflation can occur:

1. Inflation can occur as the economy grows
2. Inflation can occur as the economy recedes

These are two fundamentally different situations. They are two scenarios among other types of economic environments. For example, whether an economy is growing or receding, it could also face deflationary environments where prices go down. This has reportedly been occurring in Japan, for example.

A common axiom among economists is that technology is deflationary. This is a bit repetitive, in the sense that technology is fundamentally an innovation that increases productivity. More productive economies are generally more efficient and thus can lower prices. This is important to understand because humans are frequently innovating, thus any increase in inflation should prompt people to think about how the economy got there.

So back to the equation from above:

Let’s define the metrics shown above:

GDP = Gross Domestic Product. These are all the things we spend money on, whether it be a gym membership, food at the grocery store, rent, or even paying an accountant to do our taxes.

M = Money Supply. This is how much money is in the economy.

V = Velocity of Money. This is how fast money moves throughout the economy. Saving slows down the velocity of money. Spending increases it.

P = The price level. This is where we see inflation manifest.

T = Transactions within the economy.

We can flip around the equation to arrive at P = (M x V)/T. This means that, as P accelerates, either we would need to see M or V increase or see T decrease. So, let’s go through a few scenarios where this would happen.

Increasing the Money Supply, M in our equation, is a cause of inflation that is pervasive in the public consciousness when thinking of inflation. We opened with a quote from Milton Friedman to this effect. Images of people carrying money around in wheelbarrows come to mind. Hyperinflationary episodes such as Weimar, Germany, as well as examples that have occurred in Venezuela and Zimbabwe, are referenced often.

In this scenario, money is minted faster than goods can be created, thus running up the individual prices of those goods.

If V in our equation increases, this can also lead to inflation. This can happen for various reasons. One is more capital spending within an economy. Ordering machinery requires paying workers, who then go on to spend the money they earned. Another cause of this can be psychology. If, for example, speculators within the economy think the price of real estate is set to increase continuously, they may rush out to flip houses! As demand heats up, new homes get built and sold with fees and commissions getting paid, moving money throughout the economy.

Transactions, or T in our equation, could fall. This is what was known in the 1970s as stagflation. This scenario meant that as prices increased, supply actually fell! This is uncommon because prices rising are normally a signal for producers to make more of the things that people are demanding. Transactions do not need to fall for there to be inflation. Transactions can increase as inflation occurs within the economy, just at a slower rate than other factors increase.

It is important to note that GDP tends to move higher over time. Price certainly plays a part in this trend, but so do transactions. In the background, velocity and money supply are also working.

Gross Domestic Product (GDP) | FRED | St. Louis Fed (stlouisfed.org)

So, when looking for causes of inflation, the formula can narrow down potential suspects pretty quickly. When we look at the Velocity of Money, it appears to have fallen dramatically due to the pandemic. This is easy to explain as people stopped going out to eat and filling their cars up. This seemingly worked against increasing inflation and caused policymakers to worry about a deflationary shock not seen since the Great Depression.

Velocity of M2 Money Stock (M2V) | FRED | St. Louis Fed (stlouisfed.org)

So, when looking at the next potential culprit, the graph shows that the Money Supply has increased enough to offset the decrease in the velocity of money.

M2 (M2SL) | FRED | St. Louis Fed (stlouisfed.org)

People generally want to buy things. But production for many consumer items were greatly impacted by shutdowns during the unprecedented Covid-19 Pandemic, and supply chains are still feeling the effects.

For example, if you wanted to purchase a car to avoid exposure to germs in public transit during the Pandemic, you may need to wait for it to be produced. Unless you are willing to PAY MORE for it now. This is likely a contributing factor showing Used Car prices going up in the graph below.

Source: Consumer Price Index for All Urban Consumers: Used Cars and Trucks in U.S. City Average (CUSR0000SETA02) | FRED | St. Louis Fed (stlouisfed.org)

Definitionally, velocity and transactions are decreasing, but prices are increasing.

Much ink has been spilled over fears of the 1970’s or even worse, hyperinflation. When Ben Bernanke famously said that the Fed could print as much money as it needed on 60 Minutes, inflationistas hyperventilated.

But as shown above, if the velocity falls, then increases in the money supply do not necessarily cause rampant inflation. One potential reason for this is because of how the money was distributed throughout the economy after the Great Recession.

Financial Institutions with weak balance sheets generally received tons of support from the Federal Reserve. But some of those institutions did not start lending out money just because they received reserves from the Fed. This keeps the money supply from growing further and lowers the velocity in the economy.

Economist and investor Lacy Hunt likes to quote David Hume:

Essentially what Hunt is saying is that indebted economies utilize their money to pay down debt and see less investment in the economy as a result. In his opinion, the velocity is condemned to fall for this reason.

Source: MACROVoices Podcast, April 2020. “Dr. Lacy Hunt: The Road Through Deflation Toward Eventual Hyperinflation”

Now after the COVID lockdowns, the money disbursed by the government was distributed in a much different way. The money went to the people! At first, savings rates increased, but as the economy reopened, people started spending and the personal saving rate move back towards its pre-pandemic level.

Personal savings during the pandemic:

Personal Savings during the pandemic | Velocity of M2 Money Stock (M2V) | FRED

However, returning to the Money Velocity chart from 2020 onwards the following is illustrated:

Velocity of M2 Money Stock (M2V) | FRED | St. Louis Fed (stlouisfed.org)

Since its steep decline in Q1 of 2020, the velocity appears to have bottomed out. So, the amount of money introduced into the economy is higher still — a $1 Trillion infrastructure bill was signed into law by President Biden — and the velocity of money has stopped offsetting this increase in money.

The aforementioned Lacy Hunt has been firm that velocity should decrease further still. But what if that wasn’t the case? Investment strategist and author Russell Napier was a deflationist like Lacy Hunt, until the pandemic hit. Napier states:

Napier sees governments inducing banks to lend further. This could be by guaranteeing loans on green infrastructure or by forgiving student loans, thus encouraging more credit creation.

Source: The Market, July, 2020. Russell Napier: «Central Banks Have Become Irrelevant» (themarket.ch)

While the most conventional cause of inflation that often comes to mind is from massive amounts of printing by governments, this is typically not the only cause of inflation.

Economists have simplified the causes of inflation by looking at the equation below.

Broadly speaking causes of inflation within the economy are:

1. The money supply increases
2. Velocity of money can increase
3. The amount of transactions in the economy can fall

These can manifest in numerous ways. And it is also not an exhaustive list of potential causes of inflation. Indeed, psychological factors can also cause inflation. When people fear that their money will lose its value, they rush out to spend it, and when everyone thinks the same way, others are loathe to accept the money on offer. There are also unknown elements to inflation that cannot be fully determined or understood at this time.

Yet, today in America, it is clear that the supply of money has increased drastically. For now, the velocity of money in the economy appears to have stopped falling. The United States is expected to continue leading the global economy going forward, but the supply chain and shortages have forced transactions to lower in the meantime and the lasting effects of this is yet to be determined.