Friedman Would Be Apoplectic

Back in the 1970s, Professor Milton Friedman of the University of Chicago was at the peak of his influence on the field of macroeconomics. He was the titular head of what was called the monetarist school of economic thought. That school held that growth of the money supply was the most reliable indicator of future inflation. And, indeed, rapid growth in M1 and M2 did precede a march to double-digit inflation during the second half of that decade. Rapid growth back then was annualized rates of 10-14%.

Over the past six months, those growth rates for M1 and M2 are 70% and 38%, respectively. Over the past 12 months, 40% and 23%, respectively. Such growth rates would, presumably, have driven Professor Friedman to call for the removal of all members of the FOMC.

But, the economy today is far different than in the 1970s. Recall that the explosion in the Fed’s balance sheet (QE) in response to the “great recession” of 2008-09 also prompted forecasts of rapid inflation. Those forecasts proved to be wrong because QE did not result in rapid growth in the money supply. Growth rates of M1 and M2 remained anemic because private sector borrowing had collapsed during and following the financial crisis. Without growth in bank lending, the Fed’s provision of a huge volume of bank reserves did not produce faster growth in the money supply.

In 2020, however, there has been a big increase in private-sector and federal government borrowing–as reported in the latest quarterly Fed report. And that has facilitated the explosion in M1 and M2.

But, will that explosion lead to a big jump in inflation, as the monetarist theory would suggest? Probably not. Almost all of the recent increase in private-sector borrowing has been business borrowing. Ordinarily, such borrowing would finance increases in production, inventories and expansion of plant and equipment. Those activities would eventually pressure labor and goods markets, driving up costs of labor, raw materials and support services. Before long, the inflation indices would start to become worrisome–as in the 1970s.

Today, however, almost all business borrowing is done to stave off bankruptcy or liquidation, not to expand output. Borrowing today is an attempt to avoid an even greater collapse in economic activity, not to finance an expansion of activity. If there is no sustained expansion in activity, there would not be pressures on labor and goods markets that would lead to broad-scale price increases. Until this recession ends, there is probably no link between money growth and inflation.

Inflation of asset prices, especially financial assets, is, in my view, a more legitimate concern. There is no question that bond prices are inflated to the point where most sectors of the bond market are invitations to lose money over the next 12 months. If the economy were to recover at a sustained moderate pace in 2021, the current levels of interest rates and bond yields would probably become unsustainable, despite the Fed’s promises of low rates forever. But this forecast is not based on expectations of a big jump in inflation. That is not a prerequisite to the return of more rational market conditions. Control over the pandemic and a consequent resumption of something close to a sustainable economic recovery would be sufficient.

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