High velocity. Photographer: Andrew Harrer/Bloomberg
“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.”
It was in a lecture delivered in London in 1970 that Milton Friedman uttered those famous words, the credo of monetarism.
Over the previous five years, inflation in most countries had been on the rise. In the first half of the 1960s, U.S. consumer prices had never gone up by more than 2% in any 12-month period. The average inflation rate from January 1960 until December 1965 had been just 1.3%. But thereafter it moved upward in two jumps, reaching 3.8% in October 1966 and 6.4% in February 1970.
For Friedman, this had been the more or less inevitable consequence of allowing the money supply to grow too rapidly. The monetary aggregate known as M2 (cash in public hands, plus checking and savings accounts, as well as money market funds) grew at an average annual rate of 7% throughout the 1960s. Moreover, as Friedman pointed out in his lecture, the velocity of circulation had not moved in the opposite direction.
What no one knew in 1970, though Friedman certainly suspected it, was that much worse lay ahead. By the end of 1974, U.S. consumer prices were rising at more than 12% a year. The “great inflation” of the 1970s (which was only really great by North American standards) peaked in early 1980 at 14%. Friedman’s London audience had an even rougher ride in store for them. U.K. annual inflation hit 23% in 1975. That year, as an 11-year-old schoolboy, I wrote a letter to the Glasgow Herald (my first ever publication) that bemoaned the price of shoes, because I could see my mother’s sticker shock each time I needed a new pair. Prices were rising significantly faster than my feet were growing — and that was saying something.
In recent weeks, investors have been acting in ways that suggest they fear a repeat of at least the first part of that history — the 1960s, if not the 1970s. On Thursday, Federal Reserve Chair Jerome Powell made the latest of multiple attempts by Fed officials to reassure markets that they have nothing to fear from a temporary bout of higher inflation as the U.S. economy emerges from the Covid-19 pandemic. In response, you could almost hear the chants of “always and everywhere a monetary phenomenon.” After all, the latest M2 growth rate (for January) is 25.8% — roughly twice the rate at inflation’s peaks in the 1970s. (Yes, I know velocity is way down.)
The crucial indicator in this debate is inflation expectations. These can be measured in various ways, but one of the best is the so-called breakeven inflation rate, which is derived from five-year Treasury securities and five-year Treasury inflation-indexed Securities, and tells us what market participants expect inflation to be on average in the next five years. Less than a year ago, that expected inflation rate was down to 0.14%. Last Wednesday it was at 2.45%. The last time it was that high was in April 2011.
Highest in a Decade
Another indicator of market anxiety is the steepening of the yield curve (though that could well be capturing growth expectations as well as inflation fears). In the shock of the pandemic, the yield on 10-year Treasuries fell as low as 0.6%. Now it is up to 1.56%. Because the yields of government bonds with shorter maturities have not moved up so much, the widening spread can be seen as a further sign that markets expect inflation.
Yields Bounce Back
To some observers, including Fed economists, all this seems like market overreaction. The Fed’s preferred measures of inflation, derived from the price indices of personal consumer expenditures, have consistently undershot the 2% inflation target for most of the period since the global financial crisis. In only 10 months out of the 149 since Lehman Brothers Inc. went bust has core PCE (excluding the volatile costs of energy and food) exceeded 2%. The latest reading is 1.5%. Indeed, average core inflation has been 1.9% for the past 30 years — since the presidency of George H. W. Bush. In any case, the economy is only just emerging from one of the biggest supply shocks in economic history — the lockdowns and other “non-pharmaceutical interventions” to which we resorted to limit the spread of the SARS-CoV-2.
The Decline of Inflation
Looking at the past three decades, you can see why the Fed subscribes to what might be called the Mad Magazine view of inflation: “What, me worry?” Last month, Powell said, “Frankly we welcome slightly higher … inflation. The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time.”
Since last September, the Fed has pledged to keep its Fed funds rate at near zero and its bond purchases (quantitative easing) going until the labor market has made “significant progress” in recovering from the Covid shock. In very similar speeches last week, Fed Governor Lael Brainard and Mary Daly, president of the San Francisco Fed, reiterated this commitment. It’s not just that they don’t worry about inflation above 2%. They actively want inflation above 2% because they are now targeting an average rate of 2%.
In making this argument, the Fed folks are telling us that post-pandemic inflation will be so fleeting as to leave expectations essentially unchanged. “A burst of transitory inflation,” in Brainard’s words, “seems more probable than a durable shift above target in the inflation trend and an unmooring of inflation expectations to the upside.” Those who worry about such an unmooring, argued Daly, are succumbing to “the tug of fear … a memory of high and rising inflation, an inexorable link between unemployment, wages and prices, and a Federal Reserve that once fell behind the policy curve. But the world today is different, and we can’t let those memories, those scars, dictate current and future policy … That was more than three decades ago, and times have changed.”
Now, I plead guilty to having worried about inflation prematurely in the past, something for which I was vehemently (and unfairly) criticized by Paul Krugman and others. Eleven years later, I am not about to repeat that mistake. Yes, the administration of President Donald Trump ran the economy hot with big tax cuts and browbeat the Fed to abandon its planned normalization of monetary policy — and even at 3.5% unemployment, inflation barely moved. Yes, as Skanda Amarnath and Alex Williams very reasonably argue, the reopening of services such as bars and restaurants will likely push up PCE inflation, but not by much and only temporarily. Only if inflation is sustained and accompanied by equally sustained wage inflation would the Fed need to change its stance.
Yet this entire debate has been turned on its head by the intervention of former Treasury secretary and Harvard University President Lawrence Summers. Back in 2014, it was Summers who resurrected the idea of “secular stagnation,” predicting (correctly, as it proved) that the period after the global financial crisis would be characterized by sluggish economic performance and very low interest rates. There was therefore some consternation in the world of economics when Summers published a stinging critique of President Joe Biden’s proposed $1.9 trillion fiscal stimulus on Feb. 4.
“There is a chance,” warned Summers, “that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability.”
At this point, we need to make our first qualification of Friedman’s monetarist credo. Actually, inflation is often and in many places a fiscal phenomenon — or at least, you don’t get inflation without a combination of fiscal and monetary expansion. Summers’s point is that the proposed fiscal stimulus is far larger than the likely output gap, insofar as that can be estimated. Even before the additional stimulus, Summers wrote, “unemployment is falling, rather than skyrocketing as it was in 2009, and the economy is likely before too long to receive a major boost as Covid-19 comes under control. ... Monetary conditions are [also] far looser today than in 2009. … There is likely to be further strengthening of demand as consumers spend down the approximately $1.5 trillion they accumulated last year.”
Although economists working for the Biden administration and Democratic Party operatives shot back, Summers’s argument was endorsed by other big hitters, notably Olivier Blanchard, only recently a proponent of active fiscal policy. Martin Wolf, a rampant Keynesian in the period after the financial crisis, called the stimulus plan “a risky experiment.”
Even investors who don’t share my respect for these academic economists could hear a version of the same argument from two of the great financial market players. “Bonds are not the place to be these days,” wrote Warren Buffet in the latest Berkshire Hathaway report. “My overriding theme is inflation relative to what the policymakers think,” Stan Druckenmiller said in an interview. “Basically the play is inflation. I have a short Treasury position, primarily at the long end.”
Time for a further amendment to Friedman’s credo. Like the equation that encapsulates the quantity theory of money (MV=PQ), the assertion that inflation is always a monetary phenomenon verges on being a tautology. In truth, monetary expansions, like the fiscal deficits with which they are often associated, are the result of policy decisions, which are rooted in decision-makers’ mental models, which originate in some combination of experience and study of history. The Fed folks are telling us that inflation expectations will stay anchored, even if inflation jumps above 2% for a time. The big beasts of economics and investment may just have longer memories. Both Blanchard (72) and Wolf (74) are old enough to remember the 1960s, and both refer to what happened then with good reason.
Our own time has quite a lot in common with the 1960s, as I argued last June in the first column I wrote for Bloomberg Opinion. True, the Woodstock generation was into free speech, whereas the Wokestock generation wants to cancel it, but there’s the same sense of a generation war. There’s a crazy right, too, as we saw on Jan. 6. It’s just that today the arguments for separating black and white students are made on the crazy left.
The economic similarities are there, too. The economists who served in the John F. Kennedy and Lyndon B. Johnson administrations — such as Walter Heller of the University of Minnesota — had as much faith in the power of fiscal policy as those now serving under Biden.
“Our present choice,” declared Kennedy, “is not between a tax cut and a balanced budget. The choice, rather, is between chronic deficits arising out of a slow rate of economic growth, and temporary deficits stemming from a tax program designed to promote … more rapid economic growth.” The 1964 budget, which cut both individual and corporate tax rates, testified to the dominance of Keynesian ideas at that time. The only difference is that by today’s standards, the deficits of the 1960s were tiny, peaking at 2.8% of gross domestic product — a figure regarded as so excessive that in 1968 Congress passed the Revenue and Expenditure Control Act, effectively reversing the 1964 tax cuts.
As in our time, the Fed was confident that there was a stable tradeoff to be exploited between inflation and unemployment. As Allan Meltzer showed in his history of the Fed, the easing of monetary policy in 1967 was a grave error, one recognized by Fed Chair William McChesney Martin by the end of that year (“the horse of inflation not only was out of the barn but was already well down the road”). An important difference was the distorting effect of the Fed’s Regulation Q, which imposed interest rate ceilings on savings accounts in 1965, discouraging saving, boosting consumption, and limiting the effective transmission of monetary policy.
Then, as now, the global financial system revolved around the dollar, to the annoyance of European leaders such as President Charles de Gaulle of France, who complained of the American currency’s “exorbitant privilege.” The difference was that the dollar was still linked to gold under the Bretton Woods rules of (mostly) fixed exchange rates. Fears that the U.S. might break the link to gold and devalue the dollar — which were fulfilled by Richard Nixon in August 1971 — may have played a part in pushing up inflation expectations.
In a seminal paper first published in 1981, the economist Thomas Sargent argued that “big inflations” ended only when there was “an abrupt change in the continuing government policy, or strategy, for setting deficits now and in the future that is sufficiently binding as to be widely believed.” The corollary of this insight must be that inflations begin with a comparable regime change, but one that is imperceptible rather than abrupt.
Sargent elaborated on this point in his 2008 presidential address to the American Economic Association, in which he argued that policymakers might easily form “incorrect views about events that are rarely observed.”
The situation that we are always in [is] … that our probability models are misspecified. … The possibility [exists] that learning has propelled us to a self-confirming equilibrium in which the government chooses an optimal policy based on a wrong model … Misguided governments [fall into] lack-of-experimentation traps to which self-confirming equilibria confine them.
This nicely encapsulates the mistakes made at the Fed in the 1960s. It might well turn out to describe the mistakes being made at the Fed right now. Thirty years of very low inflation seems like the perfect basis for a wrong model.
There is one important caveat, nevertheless. The biggest difference between our own time and the 1960s is that we are coming out of a pandemic, whereas then the U.S. was sliding deeper into a disastrous war. Economic historians have long been aware that, for most of history, war has been the principal driver of moves in inflation expectations. Pandemics have generally not had this effect. The reason for this is clear. Over the long run, wars are the most common reason why governments run large budget deficits and are tempted to debase the currency. And wars that go wrong are especially likely to end in either debt default or inflation or both.
Thanks to the Bank of England, we can take a long, hard look at the history of British inflation expectations since the late 17th century. The striking point is that five out of the six biggest moves in expectations occurred in time of war — especially (as in 1917 and 1940) when the war was going badly.
Britain’s Ups and Downs
Source: Bank of England
Though the economics literature has little to say on the subject, I find it hard to believe that television news coverage of the deteriorating situation in Vietnam — for example, the Tet Offensive of 1968, which the U.S. networks misrepresented as a triumph for the North Vietnamese army and the Vietcong — played no part in the upward shift in American inflation expectations.
I would become a lot more worried about the prospects for U.S. inflation if our current Cold War II with China escalated into a full-blown hot war or even a serious diplomatic crisis over, say, Taiwan — which is a good deal more likely than I suspect most investors appreciate, as Robert Blackwill and Philip Zelikow pointed out last week.
Still, the British experience in the mid-1970s is a reminder that war is not a sine qua non for inflationary liftoff — or that the wars can be someone else’s, as was the case when the Arab states attacked Israel in 1973, the trigger for the oil shock that most people wrongly think of as the principal cause of the great inflation. Ultimately, inflation expectations can be untethered by a combination of excessive fiscal and monetary laxity without a shot being fired. If a pandemic has the financial consequences of a major war, that may suffice.
Lest anyone doubt the scale of the fiscal shock attributable to Covid-19, the latest projections from the Congressional Budget Office are now available. Even if the short-run outlook is less dire than last year’s exercise, the reality is inescapable: Not only is the federal debt in public hands now at its highest level relative to GDP since the year after World War II, but it is also forecast to soar to double that level by 2050. These are drastically worse projections than we were contemplating in 2009 and 2012.
Washington's Skyrocketing IOUs
Federal debt in public hands as a share of GDP
Source: Congressional Budget Office
The conclusion is not that inflation is inevitable. The conclusion is that the current path of policy is unsustainable. The Fed may control short-term rates but it cannot really allow long-term interest rates to rise rapidly because of the problems this would create for highly leveraged entities, including the federal government itself. This is the “unpleasant fiscal arithmetic” that inevitably arises when the stock of debt rises to approximately the level of total economic output.
On the other hand, the Fed cannot comfortably engage in full-spectrum yield-curve control without creating a situation of financial repression and fiscal dominance reminiscent of the late 1940s, another time of rapid inflation. To quote a recent paper from the St. Louis Fed, “if the Fed were to adopt such a policy and if the public perceives that the Fed is engaged in deficit financing, then it is possible that inflation expectations could rise.”
In the late 1940s and in the late 1960s, economic cooling was done by raising taxes. But no one in the new administration is talking about that, though the progressives in Congress are itching to tax the rich. On the contrary, the key members of Team Biden, notably Treasury Secretary Janet Yellen, all think the lesson of history is to “go large or go home” with deficit spending: the $1.9 trillion stimulus is the first of a number of big spending measures in prospect, with green new infrastructure next up. But that’s only the lesson of very recent history — to be precise, the first term of the Barack Obama administration, in which so many of today’s key players served.
In Charles Dickens’s “Great Expectations,” the orphan Pip comes into a fortune from an anonymous benefactor and embarks on the life of a gentleman — hence his great expectations. Only later does it become clear that the money comes from a dubious source and it ends up being lost altogether: “My great expectations had all dissolved, like our own marsh mists before the sun.”
It may ultimately be that our great expectations of inflation will dissolve in a similar way, vindicating Powell and making fools of aged economists and bond vigilantes alike. But the resemblances between our situation and the one Milton Friedman described in 1970 are striking — even if it is not quite true that inflation is always and everywhere a monetary phenomenon.
Niall Ferguson is the Milbank Family Senior Fellow at the Hoover Institution at Stanford University and a Bloomberg Opinion columnist. He was previously a professor of history at Harvard, New York University and Oxford. He is the founder and managing director of Greenmantle LLC, a New York-based advisory firm.