Bussiness News
Will QE2 Lead to High Inflation?
By
James Kostohryz Nov 01, 2010 12:50 pm
Not necessarily, and those who promote this view adhere to an overly simplistic view of the quantity theory of money.
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However, we must be careful in using monetary statistics when forecasting inflation. The changes in aggregate demand that may correlate positively with changes in the money supply represent only one side of the equation. In order to be able to properly forecast inflation, we have to know something about the other side of the equation: The supply of goods and services.
In an economy with low levels of resource utilization (labor and capital) characterized by high unemployment and high excess capacity, aggregate supply can expand relatively rapidly to meet rising demand thereby suppressing any increases in the general price level. Furthermore, the impacts of technology on rising productivity must be factored in. Finally, in a global market, trends affecting international supply must be considered.
In sum, a rise in the money supply will only be associated with inflation if a variety of other conditions on the supply side are met.
The Prospects for Inflation: International and Domestic Dynamics
As I've pointed out in various articles such as Ten Observations on the Risk of Rising Inflation, the supply of globally priced goods such as oil, metals, and food as well as other key commodities are relatively tight internationally. Furthermore, strong economic growth in resource-intensive developing economies is driving brisk demand for these commodities. Finally, the demand for credit is very high in capital-starved developing countries. Thus, combine tight supplies for key global commodities, brisk international demand, and an expansion of international credit that's being accommodated by US Fed-provided liquidity, and all of the factors are in place for price inflation in these globally priced products.
At the same time, most areas of the domestic US economy are characterized by overcapacity and high unemployment. Therefore an increase in the supply of money won't be accompanied by price increases in domestically priced areas such as housing and various services that comprise the lion's share of the US economy.
So how will all of this play out in terms of domestic aggregate price measures such as CPI?
In the US economy, well over 70% of total consumption is of non-tradable goods and services. Therefore, even substantial price increases in the internationally priced tradable area can only be expected to produce relatively modest, although non-negligible, overall increases in measures of aggregate prices such as CPI.
Conclusion
An analysis of purely domestic factors would suggest that a QE2, of the magnitude currently being contemplated, will be incapable of producing substantial price inflation in the US. Under current economic conditions, increases in the monetary base (M0) won't produce substantial increases in broad measures of the money supply due to the low demand for credit in the US. And in any event, under current conditions, increases in the money supply won't necessarily provoke inflation due to low domestic resource utilization (labor and capital).
However, if we broaden our focus to incorporate international dynamics, we can see that QE2 could drive an expansion of international credit which would "accommodate" developing country growth. This dynamic will tend to drive demand for resources such as oil, metals, and food in a context of tight international supplies.
The resulting commodity price inflation will clearly have an impact on the US. However, the impact, while not negligible, will be relatively modest due to the fact that internationally priced tradable products have a relatively low weighting in measures of aggregate pricing such as PPI and CPI.
In an economy with low levels of resource utilization (labor and capital) characterized by high unemployment and high excess capacity, aggregate supply can expand relatively rapidly to meet rising demand thereby suppressing any increases in the general price level. Furthermore, the impacts of technology on rising productivity must be factored in. Finally, in a global market, trends affecting international supply must be considered.
In sum, a rise in the money supply will only be associated with inflation if a variety of other conditions on the supply side are met.
The Prospects for Inflation: International and Domestic Dynamics
As I've pointed out in various articles such as Ten Observations on the Risk of Rising Inflation, the supply of globally priced goods such as oil, metals, and food as well as other key commodities are relatively tight internationally. Furthermore, strong economic growth in resource-intensive developing economies is driving brisk demand for these commodities. Finally, the demand for credit is very high in capital-starved developing countries. Thus, combine tight supplies for key global commodities, brisk international demand, and an expansion of international credit that's being accommodated by US Fed-provided liquidity, and all of the factors are in place for price inflation in these globally priced products.
At the same time, most areas of the domestic US economy are characterized by overcapacity and high unemployment. Therefore an increase in the supply of money won't be accompanied by price increases in domestically priced areas such as housing and various services that comprise the lion's share of the US economy.
So how will all of this play out in terms of domestic aggregate price measures such as CPI?
In the US economy, well over 70% of total consumption is of non-tradable goods and services. Therefore, even substantial price increases in the internationally priced tradable area can only be expected to produce relatively modest, although non-negligible, overall increases in measures of aggregate prices such as CPI.
Conclusion
An analysis of purely domestic factors would suggest that a QE2, of the magnitude currently being contemplated, will be incapable of producing substantial price inflation in the US. Under current economic conditions, increases in the monetary base (M0) won't produce substantial increases in broad measures of the money supply due to the low demand for credit in the US. And in any event, under current conditions, increases in the money supply won't necessarily provoke inflation due to low domestic resource utilization (labor and capital).
However, if we broaden our focus to incorporate international dynamics, we can see that QE2 could drive an expansion of international credit which would "accommodate" developing country growth. This dynamic will tend to drive demand for resources such as oil, metals, and food in a context of tight international supplies.
The resulting commodity price inflation will clearly have an impact on the US. However, the impact, while not negligible, will be relatively modest due to the fact that internationally priced tradable products have a relatively low weighting in measures of aggregate pricing such as PPI and CPI.
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Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
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