Wednesday, 18 October 2017


Money, inflation, and central banks

Posted by
December 2, 2015
in Blog

Milton Friedman famously declared that inflation is always and everywhere a monetary phenomenon.  While that no doubt remains a universal principle, it is not the same (as some people think) that inflation is a central bank phenomenon.  Certainly, before central banks were created by governments there was inflation when Spanish galleons returned from the new world loaded with gold and silver, and when prospectors discovered huge amounts of gold in California.

Nevertheless, in the past century of central banks it has become common to believe (mistakenly) that because central banks (once had) control of the amount of money in circulation, they have the power to control inflation.  For a variety of reasons (explained in some detail in my recent paper for the Cato Monetary Conference), the unintended consequence of “Quantitative Easing” (also referred to as Large Scale Asset Purchases) has been that some central banks have sacrificed their tools of monetary control in favor of credit/capital allocation policies.

The essential conclusions of my Cato paper are:

For several years, major central banks have pronounced that the objective of massive QE or LSAP is/was to raise the inflation rate. That objective has not been achieved in spite of quadrupling of the central bank balance sheet (in the case of the US). Because commercial banks are no longer reserve constrained, the historical linkage between the central bank’s balance sheet (monetary base) and outstanding money supply has been broken. Changes in the size and composition of the central bank’s assets and liabilities are unrelated to the amount of money in circulation. Without the ability to influence the supply of money, central bank open market operations have no influence on the rate of inflation. Announced changes in the overnight interbank rate target (Federal funds) have no implications for the thrust of policy actions on economic activity or the rate of inflation.

If inflation should emerge, central banks have no tools for countering the pace at which the purchasing power of money declines. In the early stages of past periods of accelerating inflation, central banks mistakenly expanded their balance sheets as they “leaned against” the rising trend of nominal interest rates as an “inflation premium” was being incorporated by both lenders and borrowers. That is, policy actions of monetary authorities were “accommodative” of the rising trend of prices. For the foreseeable future, no such accommodation will be necessary. The ballooning of central bank balance sheets has been more than sufficient to fuel extreme rates of inflation without further debt monetization. This is not a forecast that inflation will in fact occur. It simply is a statement of the new reality: whether or not there is inflation is unrelated to anything central banks do or do not do.


  1. walkerftodd December 2, 2015 5:01 PM

    I agree heartily with your analysis and conclusion. I wrote about "the problem of excess reserves" two years ago in an article published at the following link (abstract here):

    Fed Governor Lael Brainard has a few speeches and papers relevant to this topic, especially the problem of monetary policy at the zero lower bound, the latest of which was posted yesterday (1 Dec 2015) on the Board's website, ironically just ahead of Chairman Yellen's important monetary policy speech to the Economic Club of New York on more or less the same subject today. Here is the link to Gov. Brainard's speech:

    Finally, Bill Gavin, whom both of us know, and Diana Cooke at the St. Louis Fed wrote an important article (2015) comparing the Japanese experience with zero lower bound policy over the last 20 years with the Fed's experience since 2008. Here is the link:

    I had been alerted to your Cato monetary conference paper, and I hope it gets the attention it deserves. Would you agree that the Fed should give up on trying to conduct traditional monetary policy until either it shrinks the balance sheet or the economy grows into the size of the new monetary base, which might take a generation or so at traditional inflation levels? — Walker Todd, Chagrin Falls, OH

  2. Manuel Suarez-Mier December 2, 2015 4:39 PM

    Dear Jerry:
    You made a mistake in the first line of your otherwise excellent essay: what MF said is that INFLATION (not money) is always a monetary phenomenon…