Apologies for the long title. It’s a reference to one of the most famous quote in economics, which is due to Milton Friedman in 1970:

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Now, I’m not a blind Friedman hater. In fact when it comes to monetary policy, I tend to agree with him. The statement above was grounded in fact for most of history, especially during very severe episodes of hyperinflation. However, it has not accurately described the experience in the U.S. since at least 1992, and this fact is presented as a puzzle in the textbook I use for my money and banking class.

The statement above is grounded in a theory called the quantity theory of money. I’m going to skip specifics, but here’s the gist. There is an equation that must hold at all time periods, it is a simple accounting identity. That equation is:

MV = PY

where M stands for the money supply, V stands for the velocity of the money supply (i.e. how many times a given dollar bill changes hands throughout the course of a given period of time), P stands for the price level, and Y stands for real output (i.e. real GDP). Finally, note that a change in the price level is what we call inflation. In other words, if P increases, then there has been inflation.

The quantity theory is a theory about the long run, so it makes a sensible assumption: over long periods of time, the velocity of money should not change very much. In fact, it should be constant. Imposing this assumption, and using some algebra, it can be shown that to a first approximation, the equation above can be written the following way:

p = m – y

Where the lowercase letters represent percent change in each of the variables above. So, p is the inflation rate, m is the growth rate of the money supply, and y is the growth rate of real GDP.

So, if Milton Friedman, and the quantity theory, are correct, then over long periods of time and after adjusting for growth in real output, the rate of inflation should equal the growth rate of money. Inflation should be a monetary phenomenon. But look at the following chart:

Here, I have taken the 10-year moving average of inflation (measured by CPI) and the output-adjusted growth rate of the money supply (measured by M2). We can see that the quantity theory describes things very well until 1975, and then continues to do a decent job until about 1992. At that point, inflation levels off, while the growth rate of money plummets. More recently, the growth rate of money rises substantially, but inflation has remained steady.

Here’s another way of looking at the same thing:

This is a scatterplot of the same two variables, with a line of best fit going through the period 1969-1991. According to the quantity theory, this line should line up on the 45 degree line, i.e. it should go through the points (x,y) = (.03,.03), (.04,.04), (.05,.05), etc. It is a little bit too steep, but the relationship is close, and quite obvious just from eyeballing the chart.

However, for the period 1992-2014, it’s not even close. I didn’t plot the line of best fit, but due to the bottom right most blob of red points, the slope is actually negative! The quantity theory is an abysmal failure at describing the last 20 years of economic experience.

I believe that the simplest and most likely explanation for this phenomenon is that it is an example of Goodhart’s law in action, combined with improvements in policy making at the Federal Reserve. That is, one of two things happened at the Fed in 1992: first, they either started trying to hit an inflation target for the first time; second, they had always had an inflation target, but for the first time reacted to the non-monetary causes of inflation – changes in consumer behavior (and therefore velocity). In either case, the improvements in policy at the Fed triggered Goodhart’s law, in which case we would expect to see the red dots and not the blue dots in the second chart.

To see why, note that if the Fed thought that inflation was going to fall below their target (or that velocity was going to fall), they should increase the growth rate of the money supply. If they do a good job, and increase the growth rate of the money supply by exactly the right amount, then inflation will remain unchanged. In contrast, if they believed that the inflation rate was going to rise above the target, then they should decrease the growth rate of the money supply. Again, if they do this by the right amount, then inflation will remain unchanged. If the Fed is doing a god job at hitting its inflation target, what we would expect to see are fluctuations in the growth rate of the money supply, but a steady rate of inflation. Looking at the first chart, that is exactly what we have seen over the past 20+ years.

A final note, in theory, the Fed doesn’t really care what the money supply is; instead, they target short term interest rates, and let the money supply be whatever it needs to be in order to hit that interest rate target. However, that target is determined (in part) by what the inflation rate is, so in practice it’s fine to theorize as if the Fed is directly manipulating the money supply to hit an inflation target.