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Some influential commentators believe that the Federal Reserve's timing
for the withdrawal of its record monetary stimulus could be determined by
inflation expectations. (A popular measure of inflation expectations is the
difference between the interest rate on the 10-year Treasury note and the
interest rate on the 10-year Treasury inflation protected security [TIPS]).
After settling at 1.5 percent in August last year, this measure of inflation
expectations shot up in April to 2.6 percent. For most experts, including Fed
chairman Ben Bernanke, inflationary expectations are the underlying driving
force of the inflationary process as depicted by changes in the consumer
price index (CPI).[1]
(In fact there is a time lag between changes in inflation expectations and
the yearly rate of growth of the CPI [see chart].)
 
These commentators believe that there are various shocks that could
increase inflation expectations and in turn the rate of inflation. For
instance, if a sharp increase in the price of oil caused higher inflationary
expectations, this could set in motion spiraling price inflation.
If somehow expectations could be made less responsive to various price
shocks, then over time this would mitigate the effect of a price shock on
price inflation. So is there a way to make these expectations less sensitive
to various price shocks?
Bernanke and other experts believe that it is possible to bring
inflationary expectations to a state of equilibrium by means of transparent
central-bank policies. In such a state of equilibrium, they argue,
expectations are perfectly anchored or are not sensitive to changes in
various economic data.
According to this way of thinking, once inflationary expectations are
well anchored various price shocks such as sharp increases in oil or food
prices are likely to be of a transitory nature. This means that over time
price shocks are unlikely to have much effect on the rate of inflation.
Note that what matters in this way of thinking is the underlying price
inflation. Therefore, the Fed chairman and many economists believe that to be
able to track underlying inflation they must pay attention to core inflation
— percentage changes in the consumer price index less food and energy.
According to Bernanke and other experts, it is difficult to bring
inflationary expectations to a state of equilibrium as long as individuals
are not clear about the precise inflation goal that Fed policy makers are
aiming at.
Absolutely nothing is said here about the possible role that changes in
the money supply might have on general increases in prices. Without a
preceding increase in the money supply there cannot be a general increase in
prices (which popular thinking labels as inflation).
Can There Be Inflation without an Increase in the Money
Supply?
Now what is a price of a good? It is the amount of dollars paid per unit
of a good. Obviously then, for a given amount of real goods, if the stock of
money remains unchanged, the amount of dollars spent per unit of a good will
also stay unchanged (all other things being equal). In order to have a
general increase in prices we must have an increase in the stock of money.
Could inflation expectations then cause a general rise in prices without the
preceding rise in the money supply?
Let us say that on account of a sudden sharp increase in the price of
oil, people have formed higher inflation expectations. If the money stock
remains unchanged, then no general increase in prices can take place, all
other things being equal.[2]
All that we will have here is a situation where the prices of oil and
energy-related goods go up and the prices of other goods and services go
down.
Contrary to Bernanke and mainstream economists, it is changes in the
money supply — not expectations of inflation — that underpin
general rises in prices. Without support from the
money supply, no general acceleration in price inflation can take place,
regardless of inflation expectations.
In fact, various so-called price shocks tend to come mostly because of
preceding increases in the amount of dollars generated by the Fed and the
banking system.
When new money is generated, it does not enter all markets instantly. It
moves sequentially from one market to another market — there is a time
lag between changes in money supply and changes in the prices of goods and
services. For some goods the time lag tends to be short, while for others it
can be very long.
This doesn't mean that a rise in the price of a particular good cannot be
caused by a sharp fall in its supply. But a general increase in the prices of
all goods cannot take place without preceding increases in money supply.
Most economists are dismissive of the money supply as far as general
rises in prices of goods and services are concerned. The main reason for this
is that the money supply is not always well correlated with changes in
various price indexes.
On account of the variable time lag from changes in money to changes in
various price indexes it is not always possible to articulate graphically the
importance of money in driving general rise in prices.
What matters here, however, is not a statistical correlation as such but
whether it is logically possible to have a general rise in prices without a
preceding rise in money supply.
The yearly rate of increase in our monetary measure AMS[3]
from 2.4 percent in June last year to 10.6 percent in May this year raises
the likelihood of a sharp increase in the growth momentum of the CPI in the
months ahead (see chart).
The upward pressure on the growth momentum of the CPI caused by this
strong increase in money supply cannot be neutralized by a transparent policy
on behalf of the Fed. Again, this likely increase in the yearly rate of
growth of the CPI is not going to come on account of an increase in inflation
expectations but rather on account of the increase in the money supply, all
other things being equal.
In fact an increase in inflation expectations always comes ultimately in
response to rises in money supply. (An increase in the money supply pushes
prices in general higher and this in turn lifts inflation expectations.)
Conclusion
The recent increase in inflation expectations may set the timing for the
US central bank to start removing its record monetary stimulus. For the time
being, Fed chairman Bernanke and other experts believe that the various
shocks behind the increase in inflation expectations are of a transitory
nature. This means that over time price shocks are unlikely to have much
effect on general increases in prices. Hence the experts hold that as long
that the Fed remains transparent regarding its policy, these shocks are not
going to have much effect on the underlying rate of inflation. But in this
way of thinking nothing is said about the role that changes in money supply have
on general increase in prices.
Notwithstanding inflation expectations, a general increase in prices
cannot emerge without a preceding increase in the money supply. A visible
increase in the growth momentum of the money supply during June last year and
May this year has already set the foundation for a further strengthening in
the growth momentum of the CPI.
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