Interest rates and inflation rates are both rooted in the money supply-Twin Cities

Interest rates and inflation rates are both rooted in the money supply-Twin Cities


Inflation is still news and has attracted public attention. It is true-rising prices of consumer staples are what defines the “wallet problem”.

Edward Lotman

A reader wanted to know the “correlation between inflation and interest rates” and asked, “Why does the Fed’turn a blind eye’ to inflation and neglect to adjust interest rates.”

The news is timely. Two days before the June Consumer Price Index was released by the Department of Labor, I received this message in my inbox, indicating that the price has increased by 5.4% compared to June 2020, which is the largest in 13 years. Year-on-year change. June is also the second month that CPI has risen. CPI has been included in the back cover of business news for many years. These data have caused many people to question the calm words of Federal Reserve Chairman Jerome Powell. He continues to believe that these are temporary surges caused by the natural convulsions of the post-COVID economic efforts to resume full production.

Also last week, Treasury Secretary Janet Yellen (Janet Yellen), who has been in the leading role of the Federal Reserve for most of the past 27 years, was not so happy, warning that until prices return to their usual levels before COVID, “still There has been rapid inflation for several months.”

Therefore, start with the first question, that is, the correlation between inflation and interest rates. The two are related because both are rooted in the amount of money that households and businesses can use to consume, borrow, and save. But they are not closely “related” in time.

Broadly speaking, this “money supply” is the sum of all currencies, coins and banknotes in circulation plus bank deposits. Economics students learn in detail which deposits are included in precise measures such as M1 and M2. This detail is not important here.

The important thing is that relative to the quantity of goods and services for sale, the money supply will drive inflation. If the money supply grows faster than the output of goods and services in a certain period of time, their prices tend to rise. This is inflation. If the money supply grows slower than the output grows, prices will fall. There is deflation.

Understand that this is very general, introducing economic-level terms. It focuses on buying consumer goods or services with money, rather than long-term goods like land. It also ignores people’s exchange of ready-made cash for long-term and illiquid things such as stocks and bonds.

It should also be understood that although almost all economists still regard this basic dynamic—available money and available goods and services—as a potential determinant of general price levels (another term for inflation and deflation), this This relationship is not as direct and immediate as long assumed.

According to the traditional view put forward by Nobel Prize winner Milton Friedman many years ago, the expansion of the money supply implemented by the Fed from 2009 to the present should soon lead to a spike in consumer inflation. It doesn’t. This has led some people to argue that “we are in a new economy.” This echoes “this time is different”-the most dangerous word in centuries of economic history.

Now look at interest rates. This is the second part of our readers’ question. Just as there are markets for goods and services, there are other markets for currencies themselves. Not everyone with money wants to buy something now. They may prefer to hold it now for future consumption. At the same time, these savers hope to get the highest possible return from it, basically charging people who want to spend more money than they currently have in order to borrow money. The money of savers is mainly lent to borrowers through intermediaries of banks and other financial institutions.

Compared with the desire to borrow money and spend money, the willingness to save and borrow money determines the price of currency. These are interest rates.

Importantly, the availability of this currency affects general price levels (such as those we are seeing now) and changes in interest rates.

Any central bank, such as our Federal Reserve, has the right to change the money supply by tapping a pen or a computer key. It can create it out of nothing, or it can easily destroy it.

When the Fed creates more money, it lowers interest rates and makes it easier for people to consume. It also makes it easier for companies to invest in new factories and equipment. It reminds people that saving will produce lower returns. Spend instead of saving. When it reduces the money supply, interest rates rise, consumer spending decreases, and businesses reduce expansion. Economic output growth has slowed down, and may even shrink. This is a recession.

Now let us consider what happened today. As Fed officials and their supporters have said, the high CPI data listed in the past few months is mainly related to the unusual economic recession caused by the external shock of the worst epidemic in a century.

As people start projects at home, the price of wood soars, and those who are still working, mainly white-collar workers with higher incomes, are looking for better houses. For a long time, hands-on employers like logging mills have been affected by COVID-related worker distancing requirements and workers’ illnesses, and their operational capabilities have been reduced. But these prices are falling.

Air travel and tourism activities have generally collapsed. Therefore, car rental companies that usually adjust their fleets quickly have not bought new cars, nor have they put tens of thousands of low-mileage used cars on the market. The price of used cars has soared. The closed computer chip makers are making slow progress in returning to full production. The list goes on.

Therefore, one response to “blindness” is that the current inflation is temporary. Powell emphasized this, but Yellen just poured at least a small bucket of water on his optimism.

Another view is that we have experienced the longest and largest peace-time money supply expansion in more than a century. The Federal Reserve led by Alan Greenspan was very nervous in the 1990s. President George H.W. Bush rightly complained: “I reappointed him, but he disappointed me.” After the initial slowdown in the 1990s, the economy grew well and the federal fiscal situation was better than it has been in decades.

The 9/11 attacks broke currency restrictions. Then came the financial market crash in 2007-09, and now we are infected with COVID. As a result, the Fed has maintained sufficient funds and low interest rates for the past 20 years. This is unprecedented, and the Fed and other central banks will have to lift this surplus.

The problem is that for 20 years, “now is not the time” has been the slogan of the Federal Reserve, from Chairman Greenspan to Ben Bernanke to Yellen to Powell. But the longer we choose not to shrink, the less we have control over when and how hard the market will force such tightening. We will revisit this part of the question next week.

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