Printing Money Causes Inflation! Right?

Maybe? Sometimes? ...sort of?

     The recent burst of inflation brought about a blogospheric outbreak of claims of the resurrection of monetarism or the quantity equation or some such theory about why the supply of money is the key to the universe.

An easy way to throw some sand in the gears of the discussion is to say "What about QE?"

But that's a bit too easy. There's much more subtlety to unpack around the money supply and inflation questions than is commonly supposed.

Question #1: Do money supply increases cause inflation?

Let's go to the data:

Well, this doesn't help very much. This graph shows the M1 growth rate and inflation. M1 definitely grew during/post-COVID, which led to inflation, right? Yes, but this explanation works too well. We didn't exactly get inflation over 100%.

Maybe M1 is the wrong measure of money. 

M2 growth works better, though its still a bit high for inflation that didn't get to 10%. But what about the decade plus before? The story coming out of the Great Recession is that inflation stayed below target in spite of M2 growth rates floating well over 5% until around 2018.

Which brings up another question:

Question #2: Why didn't QE lead to more M2 growth?

QE is often described as an increase in the money supply, but that is not quite right. QE came in three rounds and the Fed bought commercial paper, Fannie and Freddie debt and government bonds of many different varieties.

You can see the three rounds in the three humps on the graph '08-'15 of the growth rate of the monetary base, which is the liabilities of the Fed, not the money supply. By far the largest component of the monetary base is bank reserves. In normal times, reserves get lent out and become part of the money supply, but these were not normal times. The QE funds went to bank balance sheets and stayed there.

Which is part of the answer to....

Question #3: Why did inflation appear post-COVID but not post-Great Recession?

There were non-monetary reasons (sorry, Milton) for the inflation post-COVID including supply chain disruptions and a hot labor market. Restarting the economy meant serious problems with transportation, most famously leading to 70+ container ships sitting outside the Port of Long Beach. The cost a transporting a container across the Pacific more than tripled for a time. Furthermore, millions re-entered the work force, often switching jobs in the process, pushing up costs for firms from another direction.

So the Fed and the Congress/President are not the primary culprits in the post-COVID inflation story. If you don't believe it, look up some international inflation numbers.

So let's try to give pithy, summary answers to the questions and see how far we get.

Question #1:  Do money supply increases cause inflation?

    Sometimes. It depends. 

Question #2:  Why didn't QE lead to more M2 growth?

    The QE funds stayed inside banks as reserves.

Question #3:  Why did inflation appear post-COVID but not post-Great Recession?

    The post-COVID inflation was driven (primarily) by supply shocks from restarting the economy.

Pretty good, but we've ignored an elephant in the room.

Question #4:  Why didn't the banks lend out the reserves from QE?

    The short answer is the ZLB. Interest rates can't (currently) fall (much) below zero, so if the demand for loans is weak enough that the equilibrium rate is negative, the ZLB acts are a price floor, and the surpluses build up inside the banks. In Keynesian lingo, monetary policy is "pushing on a string" in a liquidity trap.

Post-COVID, the supply shocks generated inflation pushing interest rates up off the ZLB, so that all those reserves in the banks had a place to go. The spike in the money supply was as much about the burst of lending from banks as anything the Fed did directly. Much of the inflation faded away with the supply chain and labor market factors.

Focusing solely on the money supply can be mis-leading. Its like turning on the news and watching the weatherman say, "Tomorrow, the sun will come out and warm things up. Over to you for sports, Joe." That forecast is often true, but not particularly informative. Sunshine usually does increase temperatures, but exceptions exist, and there are other factors to examine to understand the weather.

More money often means higher prices, but the ZLB is a big exception. Understanding financial flows of funds is important, but the money supply is just the headline, not the whole story.