Why Has the U.S. Not Seen Rising Inflation Resulting from Increases in the Money Supply in the Post-2008 World?
In order to counteract the contractionary pressures stemming from the events in 2007-2008, the Federal Reserve conducted expansionary monetary policy by facilitating a massive expansion of the monetary base as shown in the graph below from the Federal Reserve’s Economic Data (FRED). Consequently, the Federal Reserve later used unconventional monetary policy such as quantitative easing to stimulate the economy as the federal funds rate approached the zero lower bound. As a result, some pundits became worried that this massive expansion of M0 would lead to high levels of inflation .
However, nearly 10 years after 2008, high levels of inflation have failed to materialize, as evidenced by the chart below showing percentage change of the CPI indexes. Likewise, annual numerical data from the Fed as well as multiple other price indexes show that inflation has not spiraled out of control since 2008. In order to understand why this had occurred it is necessary to utilize theory concerning (1) the quantity theory of money, (2) the money multiplier, and (3) the anchoring of expectations concerning future inflation.
According to the Quantity Theory of Money:
The idea that vast expansions in the monetary base will lead to proportional changes in the price level is a view reliant on the quantity theory of money . This approach ultimately implies, at least in the long run, a close positive relationship between the change in the quantity of money and change in price level, inflation. Hence, the lack of significant inflation in the U.S. since 2008 is a surprising find for adherents of this theory. Therefore, we must consider that the relationship implied by the quantity theory of money has somehow broken down due to systemic changes. In fact, this relationship had to have broken down considering that , according to the quantity theory of money, “[I]nflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent”.
The key change is a drastic fall in the velocity of the money supply in the post-2008 economy, which can be seen in the graph below. Usually assumed fixed in the quantity theory of money due to its gradual rate of change, the fall in velocity can explain much of the lack of inflation due to the Federal Reserves asset purchases and other methods of expanding the monetary base. Yi Wen, writing for the St. Louis Federal Reserve, noted the following concerning declining velocity:
“This [declining velocity] implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP (either P or Q).”
This change in velocity is partly driven by the hoarding of the money supply due to the high level of economic uncertainty in the years after 2008. In uncertain times economic actors are less likely to spend on consumption or investment and instead save money which reduces velocity. Consequently, low interest rates also impact velocity; Wen writes that:
“[D]uring the prerecession period, for every 1 percentage point decrease in 10-year Treasury note interest rates, the velocity of the monetary base decreased 0.17 points…Since 10-year interest rates declined by about 0.5 percentage points between 2008 and 2013, the velocity…should have decreased by about 0.085 points. But the actual velocity has gone down by 5.85 points…This happened because the nominal interest rate on short-term bonds has declined essentially to zero… the best form of risk-free liquid asset is no longer the short-term government bonds, but money”.
What About the Money Multiplier?
Another avenue for exploring the low inflation experienced in the U.S., despite the vast expansion of the monetary base, is changes in the money multiplier. Specifically, there was a substantial fall in the multiplier after 2008 as shown in the graph below. This fall implies that expansions in the monetary base no longer lead to such substantial increases in the broader money supply as they once did. Notably (to Greg Mankiw) with the multiplier slipping below one, each increase in the monetary base of one dollar results in less than one dollar of increased money supply. Similarly, John Williams writes in 2012 that, “Despite a 200% increase in the monetary base, measures of the money supply have grown only moderately. For example, M2 has increased only 28% over the past four years”.
Ironically, this change in the money multiplier is largely driven by the hoarding of reserves by financial intermediaries as a result of the new Federal Reserve policy of paying interest on reserves held at the Fed. While this policy is intended to increase Federal Reserve ability to manage the economy by providing a floor to the federal funds rate, it has also diminished incentives for institutions to loan money, therefore, decreasing the multiplier effect. As the graph below shows, the explosion of reserves held at the Federal Reserve coincided with the introduction of the Fed’s policy to pay interest on reserves.
Consequently, Williams writes that:
“[T}he historical relationships between the amount of reserves, the money supply, and the economy are unlikely to hold in the future. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. As a result, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid”.
Ultimately, much like the decline in the velocity of money as a result of uncertain economic agents holding money, the fall in the money multiplier reflects financial intermediaries hoarding reserves due to Fed policy and uncertainty in the lending market. This, in turn, impacts the amount of money in the broader economy which impacts the rate of inflation as a result of Fed actions. Finally, as a side note, I would like to acknowledge the problems with the money multiplier model and its loss of validly in reflecting economic reality in recent decades. However, I incorporate the model into my explanation of inflation rates in the U.S. because of its usefulness in conceptualizing the relationships between the level of reserves, the lending behavior of financial intermediaries and broader measures of money creation.
Finally, the discussion of low inflation post-2008, despite large increases in M0, would not be complete without mention of inflation expectations and anchors since modern economic theory attributes these as factors in the determination of the actual inflation rate. Ben Bernanke emphasizes the importance of these considerations in a speech in 2007, noting that inflation expectations have become increasingly anchored over the past 30-40 years so that:
“To the extent that the Phillips curve may have flattened, inflation will now tend to be more stable than in the past in the face of variations in aggregate demand. (Of course, this can be a good thing or a bad thing, depending on whether inflation expectations are anchored in the vicinity of price stability.) Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago”.
Looking at the graphs above, there is evidence that inflation expectations have remained relatively well anchored over the short and medium term time horizons considering the economic circumstances and the expansion of the monetary base. Consequently, Janet Yellen appears to hold this view as well, as she noted in a 2015 speech that data on inflation expectations suggests that they are well anchored post-2008. In fact, Yellen comments that,“Since the late 1990s, survey measures of longer-term inflation expectations have been quite stable; this stability has persisted in recent years despite a deep recession and concerns expressed by some observers regarding the potential inflationary effects of unconventional monetary policy”. Consequently, an article from the Cleveland Federal Reserve also concludes that unconventional monetary policy, namely quantitative easing, by the Federal Reserve did not significantly alter inflation expectations in either the short, medium, or long run.
Therefore, to the extent that inflation expectations are anchored around the Fed’s inflation targets at different time horizons, the impacts of various monetary or economic shocks on inflation are mitigated as economic actors continue their price setting behavior in line with their anchored expectations. Therefore, Yellen notes that as a result of the anchor “[T]he central bank can “look through” such short-run inflationary disturbances in setting monetary policy, allowing it to focus on returning the economy to full employment without placing price stability at risk”. The Fed’s unconventional monetary policy and massive increase in the monetary base seems to reflect this logic; given the inflation anchor that the Federal Reserve had worked to establish, it could pursue a more accommodative, loose money policy, without causing high levels of inflation.
This discussion has included three potential explanations for why the U.S. has not experienced high levels of inflation in the years since 2008 due to the expansion of the monetary base through Federal Reserve policies intended to stimulate the economy. While these explanations of inflation have been presented separately, there is no reason to think that they are mutually exclusive or that other explanatory variables have been omitted from the discussion. Hence, while the quantity theory of money and money multiplier approaches would have certainly predicted much higher levels of inflation, changes in the velocity of money as well as the money multiplier has prevented this from occurring. Consequently, inflation expectations have remained anchored which has perhaps worked to tame inflationary pressures.